Synopsis:

Bank of America (BofA) identifies the euro (EUR) as at equilibrium in real effective exchange rate (REER) terms, but sees EUR/USD undervalued by approximately 18%, with a long-term equilibrium near 1.24. The undervaluation is attributed primarily to USD overvaluation, suggesting that future adjustments will likely occur via USD weakness rather than EUR strength.

Key Points:

• Behavioral Equilibrium Exchange Rate (BEER) Analysis:

  • BofA employs a cointegrating regression model using dynamic ordinary least squares (DOLS) for equilibrium estimates.
  • Monthly and quarterly variables are lagged to avoid "look ahead" bias.

• Current Valuation:

  • EUR is broadly at equilibrium in real effective terms (REER).
  • EUR/USD undervalued by ~18%, with an equilibrium level estimated at 1.24.
  • The EUR is undervalued versus USD and CHF but overvalued relative to JPY and Scandinavian currencies.

• Adjustment Pathway:

  • The undervaluation stems from the USD’s overvaluation rather than EUR weakness.
  • The adjustment towards equilibrium is likely to occur through USD depreciation rather than EUR appreciation.

Conclusion:

While the EUR itself is at equilibrium in REER terms, the significant undervaluation of EUR/USD underscores the potential for adjustment driven by a weaker USD rather than euro strength. Long-term equilibrium for EUR/USD is estimated at 1.24, suggesting meaningful upside over time if USD weakness materializes.