LONDON: Currency watchers have decreed that the euro will fall sharply against the dollar as Europe and the United States’ monetary policies diverge, but history suggests the euro’s drop may not be quite so smooth or rapid.

Frankfurt has started to pump cheap money into the euro zone to try to get banks lending again, boost a stubbornly unwell economy and lift prices currently rising at their slowest in five years. Meanwhile as the US economy revives, Washington is preparing to halt its six-year stint of doing the same.

As a result the euro has fallen nearly 10 per cent against the dollar since mid-May. Goldman Sachs predicts a further 20pc fall to parity by the end of 2017, Deutsche is going for a 25pc slide to $0.95 and almost every other major financial institution expects further weakness to some degree.

However, patterns in capital flows and market positioning, along with likely opposition from the United States to a surging dollar and past intervention by emerging market countries, suggest, along with lessons from Japan’s 20-year fight against deflation, that this euro-dollar play may not be so simple.

Right now, plenty agree with Goldman and Deutsche’s assessments: On the Chicago Mercantile Exchange speculators amassed their biggest bets against the euro last month since July 2012. Several investment banks say their clients’ positions are stretched.

Barry Eichengreen, professor of economics and political science at the University of California, Berkeley, believes that can only confirm a rethink is due.

“When everyone is lined up on one side of the foreign exchange market, that’s a sure sign that the exchange rate is about to move the other way,” he said.

“Deflation makes for a deceptively strong currency,” explains Eichengreen.

“Just as inflation and depreciation go together, deflation and appreciation go together. The parallels with Japan are direct.”

After Japan’s property and stock bubbles burst in the late 1980s, it embarked on a long battle to ward off deflation, rebuild a banking sector crushed by bad debts and revive growth.

That involved Japan’s central bank expanding its balance sheet on an unprecedented scale to flood the financial system with cash — while the world’s second largest economy ran a huge current account surplus, boasted a healthy domestic savings rate and a rapidly ageing population.

All these conditions broadly apply to the euro zone today.

Yet the yen did not weaken during Japan’s two “lost” decades, at least not nominally. It strengthened by as much as 90pc against the dollar by the end of 2011 and today it is still up 35pc against the dollar since 1990. Deutsche dismisses those comparisons.

Back then, it points out, Japan’s central bank wasn’t easing as aggressively as the ECB is now, so liquidity was tighter and real yields were higher. And domestic investors were not deterred Japan’s huge debt: They own more than 90pc of the Japanese Government Bond market.

However in Europe, Deutsche expects rock bottom investment returns and an annual current account surplus of around 400 billion euros to drive capital out.

Published in Dawn, October 14th , 2014