As the EUR/USD once again challenges its all time highs the question facing the FX market in Q3 of 2007 is how high can it go? Euro?s strength against the greenback can be summarized in two simple words - relative growth.
Eurozone GDP growth in Q1 registered a reading of 3.1% while US GDP for the same period printed at a paltry 0.7%. Furthermore, as 2007 moves forward few analysts project a strong recovery in US demand, while Euro-zone growth continues to surprise to the upside. Therefore, currency traders are now anticipating two rate hikes from the ECB by year?s end, but expect the Fed to remain neutral during the same period. Such disparity in monetary policy expectations has skewed order flow heavily in the favor of the euro as speculators allocate capital to the currency with the greatest possibility of the most immediate rate hike. If the Euro-zone economic growth matches its performance in the first half of the year, the prospect of 4.5% short term rates by the end of 2007 should entice more momentum players to join the fray and could lift the pair to 1.40. However, the rise in the EURUSD is not a foregone conclusion. The unit will likely face serious political opposition should it appreciate too rapidly. This may force the ECB to be less aggressive than the market expects souring sentiment against the unit if the projected rate hikes do not materialize. On the other side, US growth, while certainly hobbled by the troubles in housing, continues to remain positive and any suggestions of a near term recession appear misplaced. The lower dollar has boosted exports and tourism while job creation remains at a steady pace keeping Fed policy neutral for the foreseeable future. In short with positive interest rate differential still in its favor, the dollar could see some support if US growth does not deteriorate further.
[B]US - Consumer Tapped Out, but Sub-Prime Problems Contained[/B]
Although US Personal Spending and Personal income figures did not receive much coverage in the currency market, they were perhaps the most telling Q2 US economic releases. In both April and May the spread between personal income and personal spending turned negative - an ominous sign that the US consumer may be tapped out. In April income actually declined by -0.2% while spending grew at 0.5%. In May incomes bounced back to 0.4% but spending increased by an even greater 0.5%. Faced with flat wage growth versus rising debt service and energy costs, the US consumer is clearly being squeezed from both sides of the ledger, and this dynamic bodes badly for any hope of future pick up in growth. As has been the case all year long, oil and housing remain key to the health of the US economy, but as we approach the second half of the year their importance may become even more critical than at the start of 2007.
With oil hovering at $70/bbl and gasoline persistently at $3/gallon the US consumer has been forced to divert a greater portion of his discretionary income to transportation. Furthermore, increases in transportation tend to quickly seep into the rest of the economy. While core CPI gauges have been relatively muted, headline numbers have increased materially from 2.1% annual rate at the start of the year to 2.7% average rate over the past 3 months. Some analysts have estimated that the true rate of inflation is presently running between 4%-8% per annum. Little wonder then that with such a sharp rise in cost of living the US consumer is feeling pinched.
The situation is further aggravated by the persistent slide in housing values which resulted in very weak sales for the sector. The annualized rate of New Home Sales have declined from 2MM units a year ago to barely 900K in the latest monthly survey. Although many analysts have argued that the housing decline has bottomed out the latest data disproves that thesis. In the next twelve months over $1 Trillion worth of adjustable rate mortgages are due to be reset. With interest rates now considerably higher than when many of these 2 year terms were initiated, the potential for much higher mortgage costs is enormous. Many households may face a near doubling of their monthly payments. Furthermore, the recent woes in the sub-prime market which saw the near collapse of two multi-billion dollar Bear Sterns hedge funds have had a chilling effect on the issuance of new credit. The latest announcement from S&P and Moody?s that they will review the credit ratings of various tranches of Asset Backed Bonds suggests that credit quality of many of these loans will be marked down and credit criteria for issuance of new mortgages will go up. The net result of these developments is that the considerably more stringent credit terms from lenders have thinned the pool of potential buyers, driving down property values. That in turn has significantly reduced the use of Mortgage Equity Withdrawal to finance household purchases which was formerly a very potent source of additional income for US consumers.
Still, despite the myriad problems in housing, sub-prime woes remain contained. Key money center banks appear to be largely unaffected by the many blow ups in the sector having sold off most of these loans in securitized packages. Those banks that did run into trouble such as HSBC were able to absorb the losses without incurring any fatal injuries to their balance sheet. Even Bear Stearns which has had to admit that both of its sub prime hedge funds are now worthless, remains in strong financial shape as most of the capital risk was assumed by investors in the funds. In short, while the sub-prime mess continues to be a negative factor with respect to liquidity, it has so far failed to create any structural damage in the US financial system and therefore appears to have a limited negative impact on US economy.
[B]Weak Dollar to the Rescue?[/B]
However, despite these serious problems, the US outlook is not entirely bleak. The economy continues to generate jobs albeit at a moderate pace and manufacturing expansion remains well above the 50 boom/bust level. Recent string of surveys from Empire to Philly Fed to Chicago and most importantly ISM Manufacturing have shown a steady rise in all the indices. ISM Manufacturing has improved from a 49.7 reading at the start of the year to 56 by the end of June. A weaker dollar has certainly helped the industrial sector making US products more competitive especially against European counterparts. Furthermore, it has spurred greater tourism into United States, stimulating demand in key hospitality and restaurant sectors. For now at least export growth has managed to offset some of the most negative effects of the implosion in housing while tourism demand has injected much needed spending in the service sector. Furthermore, as long as the job cycle remains virtuous the greenback is in little danger of a collapse. Jobs create new incomes to service key debt obligations of US consumers and fuel any additional consumer demand.
Still the question ahead is whether growth in corporate demand will be able to fuel growth in the broader economy. There are few troubling spots on the horizon that point to the fact that industrial demand may have peaked as well. In their first negative reading in four months, durable goods for the month of May contracted sharply by -2.8% vs. -1.0% expected. More troubling was the steep fall in auto sales for June. GM, saw its numbers plunge by -23% from the year prior while the overall vehicle sales rate collapsed to 15.6 million units from 16.2 million the month prior - the lowest reading since hurricane Katrina. If these data points indicate a turn of trend in the industrial sector, than they will negate the dollar bullish thesis and could potentially lead to new lows for the greenback.
[B]Fed - Hawkish Bias Sole Prop For the Dollar[/B]
Despite relatively strong evidence of a slowdown in the economy, US monetary policy is unlikely to loosen for the rest of the year. As we recently noted in one of our reports, "If you want to know why the Federal Reserve refuses to budge from their hawkish inflation bias, all you have to do is look at the price of oil. Since the beginning of the year, crude prices have increased over 40 percent with the price per barrel now back above $70. Oil prices have a big impact on inflationary pressures both here in the US as well as globally. "Indeed, the Fed made the same point in the latest FOMC statement noting that, "Readings on core inflation have improved modestly in recent months. However, a sustained moderation in inflation pressures has yet to be convincingly demonstrated. Moreover, the high level of resource utilization has the potential to sustain those pressures. In these circumstances, the Committee’s predominant policy concern remains the risk that inflation will fail to moderate as expected."
Fed?s continued bias towards inflation rather than growth remains the single greatest fundamental support for the dollar. At 5.25% the greenback yields are still superior to that of the euro providing a 125 basis point positive spread. It is, however, unlikely that the Fed would consider another rate hike, unless headline inflation suddenly spiked well above 3%. Instead, dollar longs may be vulnerable to a rate cut at the very end of the year if consumer slowdown led by housing turns into an actual economic contraction. The key variable to watch going forward will be employment. As long as monthly NFP numbers print at 100K or above the Fed will be free to keep rates at current levels. However, should employment growth begin to falter as H2 of 2007 progresses, the pressure to loosen monetary policy will grow tremendously. It will be particularly intense due to the upcoming US 2008 elections as monetary officials will be lobbied mercilessly by politicians to stimulate the economy ahead of the election cycle.
[B]Euro- All Systems Go But Political Risk Remains[/B]
Ever since European growth first surpassed US growth in the second half of 2006, the EURUSD has been on a tear. Furthermore, despite significant appreciation in the value of its currency, the export depended Euro-zone region has seen little negative impact on the rate of that growth. In fact latest reading suggest that the 13 member union continues to see robust expansion as we head into the latter half of 2007. Latest EZ reading from both PMI Manufacturing and PMI Services surveys, printed at 55.6 and 58.3 respectively well above the 50 boom/bust line. The unemployment rate in France hit a 25 year low and French consumer sentiment registered its best reading since the survey began providing further evidence that the Eurozone recovery is spreading to the region?s second largest economy. The French news bodes especially well for euro hawks looking for another rate hike out of the ECB in the near term because it allows the central bank to maintain its hawkish bias by demonstrating that its policies have not hurt growth.
Nevertheless, politics may be a key risk for the euro in the next six months. While the election of Nicolas Sarkozy was generally hailed by the markets as a euro positive event, Mr. Sarkozy despite his free market philosophy is an avowed euro dove. He believes that the ECB holds too much power in setting monetary policy at the expense of finance ministers in the region, noting once that the “Euro does not belong to Trichet.” As long as growth and most importantly employment in the Eurozone continues to improve, Mr. Sarkozy is likely to remain quiet on monetary policy matters. However, should employment growth slow, especially as the EURUSD begins to approach the 1.40 level, expect the French President to raise his rhetoric accordingly.
His influence may be already seen in the reticence of the ECB officials to raise rates to 4.25%. During the latest press conference, ECB President Jean Claude Trichet made all the familiar statements regarding the need to control inflation, but did not use the keyword “vigilance” to signal an upcoming rate hike. The central bank clearly does not want to see the EUR/USD at 1.40 and Trichet even went so far as to say that “we are in domain (in regards to exchange rates) where it is very important to be responsible.” An ultra strong currency could eventually reverse the recent trend of growth in the Euro-zone and Mr. Trichet appears mindful of that fact. The net result is that for now the yield curve has only priced in 1 rate hike rather than 2 for the euro for the rest of 2007. That may be the biggest threat to the euro rally. With the currency market so primed for 50bps of tightening from the ECB, the realization that it may not come, could deflate some of the speculative demand for the unit and reverse part of the latest up trend.
One final factor to watch will be the Euro-zone consumer. Up until now, the consumer has been the weakest link in the EZ recovery. For example, the latest EZ Retail Sales continue to miss printing -0.5% vs. 0.0% expected. Part of the problem has been structural in nature, as the increase in Value Added Taxes in Germany at the start of 2007 greatly depressed consumer demand. However, with the employment situation improving, consumer sentiment appears to be rebounding as well. If the EZ consumer finally comes out of hibernation and begins to spend, the simulative effects of such behavior may prompt the ECB to become more aggressive on the monetary front. For now, the central bank continues to follow a cautious policy course that may not justify the recent powerful run up in the currency.
[B]Conclusion[/B]
As the currency market enters the second half of 2007, the EURUSD hovers near record highs. Certainly the euro has many positive factors supporting its appreciation. The superior growth in the Euro-zone which has outpaced that of the US since the second half of 2006 has been the prime catalyst for a more aggressive monetary policy from the ECB which may push rates higher by 50bp before the year end. Meanwhile, growth in US continues to sputter with the decline in housing weighing on broader consumption. Nevertheless, the lower dollar has been positive for exports and growth in the corporate sector may provide the much needed boost to the overall economy. Still the best that can be said of the greenback is that the Fed will likely maintain rates at the current 5.25% level providing the dollar with a positive spread against the euro and limiting the latter?s upward trajectory. Yet the euro?s rise to 1.40 is by no means guaranteed. The unit faces pressures from politicians in the region fearful that a highly appreciating currency will slow economic growth. That may in fact force the ECB to be less aggressive than it wants and create disappointment amongst speculators looking for a far more hawkish posture from the European central bankers
[B]Technical Outlook[/B]
The EURUSD is trading at an all-time high and many are wondering how much higher the currency pair will go. Near term, the pair is likely to face stiff resistance from the line drawn off of the December and April highs, near 1.3900. The rally from 1.2482 (October 2006 low) could be an ending diagonal. An ending diagonal consist of overlapping waves and often occurs at the end of large moves. In Elliott, wave 3 can not be the shortest wave. Since wave 1 (from 1.2482) is 882 pips and since wave 3 (from 1.2865) is 815 pips, then the limit for wave 5 is 1.4076. Within the diagonal, this is where wave 5 would equal wave 3. Diagonals are usually fully retraced, thus we would look for a return to the origin of the diagonal, near 1.2500. An alternate count is very bullish and has the EURUSD currently in a 3rd wave within a 5 wave rally that began at 1.2865. The bullish objective is at the 161.8% extension of 1.2865-1.3680/1.3261 at 1.4580. 1.4076 is the key. The counts are the same until the 1.2482-1.3364 rally. In the first scenario, 1.2482-1.3364 is wave 1 of the diagonal. In the second scenario, 1.2482-1.3364 is wave 5 of the 5 wave rally from 1.1638, which completes larger wave 1. The decline from 1.3364-1.2865 would then be larger wave 2 and larger wave 3 would be underway now. If the former pattern is correct, then price will top before 1.4076 and head towards 1.2500. If 1.4076 gives way, then we favor the EURUSD extending to 1.4500. In summary, 1.4076 is the key.
[B]EUR/USD Daily Chart (Source: TradeStation 8.2)[/B]
