In October of last year, when the last European crisis risk flare was peaking, we explained in gruesome detail [3] the paradox of Euro strength in the face of crushing fundamentals - namely repatriation (or as BofAML calls it 'deleveraging'). Since the crisis hit in early 2010, EURUSD has average 1.35 - about 11% above its historical average - and in PPP terms, EURUSD has been overvalued by an average 18% during the crisis (over 8% above its overvaluation since the Euro was introduced). The mystery is over. Just as we said, it is bank deleveraging, as evidenced by the chart below which shows a massive $4 trillion (or 42.8%) drop in Eurozone banks' foreign assets since the peak in early 2008. At the same time the reduction in foreign bank claims from the Eurozone over the same period was only $0.4 trillion. As BofAML note, 'even if some of the Eurozone’s bank claims were not converted back into euros, these magnitudes are large enough to suggest a strong positive impact on the euro.' The concern remains that the recent weakening of the EUR has to do with increased risk aversion, the deterioration of the Eurozone crisis, and global policy uncertainty as they suggest in the short-term the worst of the deleveraging may be over thanks to ECB bank support measures - but with such a vicious circle of flow, the squeezes could be painful if the paradox of further crisis escalation hits and drives EUR stronger on these deleveraging flows starting again.
[4]
Source: BofAML