EUR/USD Outlook: 1.50 on the Horizon?

The third quarter of 2007 was a great time to be long Euros. In July when we published our quarterly Forex market outlook, the Euro was trading at 1.3650. Three months later, the currency has rallied 630 points against the US dollar to hit a record high of 1.4282 on the last trading day of the quarter.

Now that we are above 1.40, the next obvious target is 1.50. Whether we will get there or not will be contingent upon many things including how many interest rate cuts the Federal Reserve will deliver, if the US economy will fall into a recession and how the European Central Bank will respond to the strong Euro.
[B]US Dollar Falls to Record Lows: How Did We Get Here?[/B]
The main reason why we have seen such remarkable strength in the Euro is not because of stellar economic conditions in the Eurozone, but because of the deteriorating economic conditions in the US. Although the housing market had been struggling for months, its true problems did not surface until the third quarter. Bad loans, particularly in the sub-prime sector, increased significantly, and in late June, leading banks on Wall Street began to report major losses for their hedge funds. In July, AXA Investment Managers closed one of its funds to new investors, BNP Paribas suspended three of their funds, Goldman Sachs was forced to rescue one of their funds and Sentinel, a major US money manager halted redemptions. A snowball affect was seen across the financial markets creating a liquidity crisis that forced the European Central Bank and the Federal Reserve to pump billions into the financial system. The subprime crisis then went global, hitting hedge funds and mortgage lenders in countries like Germany, Australia and the UK. Australian mortgage lender RAMS Loans Group saw its shares crash 60 percent in the middle of August as the US credit squeeze left the lender unable to refinance $5 Billion in debt.
Unsurprisingly, this chain reaction led to a wave of layoffs in the financial sector. America’s biggest mortgage lender Countrywide Financial cut 12,000 jobs. Citigroup warned of 60 percent earnings drop in the third quarter while UBS disclosed $3 billion worth of losses. In the month of August, non-farm payrolls fell by 4k, the first drop in four years. Consumer confidence fell to a 2 year low, driving retail sales excluding autos down 0.4 percent. All of these factors stoked fears that the US economy could fall back into a recession. The risk as well as the conditions in the credit markets and the deterioration in economic data forced the Federal Reserve to cut interest rates for the first time since 2003, but the tables turned in October.
[B]Will the Fed Continue to Lower Interest Rates?[/B]
The credit markets began to stabilize, the spread between US Treasury and junk bonds receded from its highs, the stock market rebounded 800 points following the interest rate cut and the non-farm payrolls report for the month of September signaled stability in the labor market. All of these factors have shifted the market’s expectations for future interest rate cuts significantly. Fed fund futures went from pricing in 50bp of easing by the end year to only 25bp by Christmas with a 50 to 50 percent chance that it will happen in October.
When a central bank lowers or increases interest rates after remaining on hold for many months, their first action is usually not their last. In the case of the Federal Reserve, they have cut interest rates after remaining on hold for the past year and we still expect them to deliver at least one more rate cut before the end of the year. Despite the recent strength of payrolls and the relative stability of the financial markets, a lot of economic data is due for release between now and the October 31st interest rate announcement. With the number of adjustable rate subprime mortgages resets hitting a peak in October, foreclosures are expected to grow. The housing market is already in a downward spiral as inventories rise while new, existing and pending home sales continue to decline. Yet the fact that the US economy did not actually lose jobs in August, but instead added 89k jobs reduces the risk of a recession, at least for the time being. If jobs are plentiful, then consumer spending could hold steady. Retail sales are not due for release until October 12th along with inflation data before the Fed rate decision. As long as none of these numbers are horrible, the US dollar could retain its strength going into the rate decision. However if the data disappoints, then the dollar will weaken as rate cut expectations quickly adjust themselves in favor of another cut later this month. For the Fed, the decision on when to lower interest rates next and by how much will be contingent upon what could damage the economy most -, growth or inflation. At the beginning of September, the drop in non-farm payrolls indicated that growth was the bigger problem. Now that payrolls have stabilized, the Fed may shift its focus to inflation.
[B]Worries about Inflation[/B]
Inflation pressures are a serious concern for the Fed not only because commodity prices have hit record levels, but the US dollar is also weakening. Commodities saw the biggest monthly gain in over 30 years last month thanks to the rise in wheat, crude oil and gold prices. Many other grain prices have also been dragged higher while the commodity boom extends to things like lead and platinum. In August, inflationary pressures were modest at best with headline consumer prices actually dropping by 0.1 percent. Core prices grew by 0.2 percent. Although the Fed generally focuses on core prices, there is increasing dissent within the Federal Reserve as to whether this is the appropriate focus. On October 4th, Dallas Federal Reserve Bank President Fisher cautioned against ignoring headline inflation. He said that increases in food and energy prices could represent “longer-lived trends rather than transitory blips.” Also, the weaker US dollar is inflationary because it increases the costs of foreign goods. Collectively, the threat of inflationary pressures is one of the main reasons why the Federal Reserve may be extra conservative about lowering interest rates in the monetary policy meetings to come.
[B]Weak Dollar to the Rescue?[/B]
Do not expect US officials to stand in the way of further dollar weakness because the US economy needs a weaker dollar. Not only does that increase foreign demand for US goods, but it can also spur renewed foreign investment. There are three different ways that foreign investment can help buffer any slowdown in the US economy and the US dollar. Over the past few years, foreigners have been big buyers of US real estate. According to a study by the National Association of Realtors, about one in five American real estate agents sold a second home in the year ending April 2007 to a foreign buyer. A third of these buyers come from Europe, a quarter from Asia and 16 percent from Latin America. As the US dollar continues to fall in lockstep with house prices, foreign buyers could provide the support that the US housing market needs to avoid a major crash. The second support could come from the US equity markets. If the dollar continues to fall, foreign investors may begin to acquire companies with sound fundamentals that are also less vulnerable to a US economic slowdown. Both of these factors are contingent upon the US dollar showing signs of stabilization. Foreign investors will only swoop in with size when they believe that dollar weakness is nearing an end. The third factor is less contingent upon the outlook for the US dollar which is that a weaker dollar also makes US corporations more attractive buyout targets. Sovereign wealth funds of countries like China and Dubai are flush with cash and they are on the lookout for good investment opportunities.
[B]Eurozone Growth: Showing Signs of Weakness[/B]
Although the developments in the US will play a bigger role on where the EUR/USD is headed, it is important to follow the trends in Europe as well. For the majority of 2006 and the first quarter of 2007 the Euro’s rally was driven by the organic strength of the Eurozone economy. In Q1 of 2006 as EZ GDP growth exceeded US GDP growth for the first time in years, the currency followed suit, rallying from 1.20 up to a high above 1.42. In the second quarter however, which is the latest GDP data that we have received at the time of publication, US GDP growth of 3.8 percent surpassed the Eurozone’s GDP growth of 2.5 percent once again. While this is a lagging indicator, more signs of weakness in the Eurozone economy are emerging. Despite unemployment at the lowest level in 14 years, German retail sales fell by 1.4 percent. With business and consumer confidence both waning as a result of the sharp appreciation in the Euro, high oil prices and banking sector turmoil, growth in the third and fourth quarter could slow even further. The only support for Eurozone growth will be from exports to countries like Brazil, Russia, India, Saudi Arabia and China. In fact, Russia now imports 10 times as much from Europe as they do from the US. In the meantime however, EZ growth is only beginning to show signs of weakness which is why for the time being, the European Central Bank is not all that concerned.
[B]European Central Bank: Has Interest Rates Peaked?[/B]
Instead, the European Central Bank is focused almost exclusively on inflation. At the most recent monetary policy meeting held on October 4th, the European Central Bank left interest rates unchanged at 4 percent. Although the Euro initially sold off on the back of this announcement, it recovered quickly following ECB President Trichet’s press conference. Despite repeated attempts by reporters to get him to address the level of the Euro or its impact on the economy, Trichet said point blank that he is not going to comment on the currency. The only things that he is willing to say are that it is important to exercise verbal discipline on exchange rates, exchange rate volatility is very counterproductive and he would appreciate a US position on the strong dollar. President Trichet was very explicit in expressing his concerns about inflation. The ECB believes that inflation will remain above their 2 percent target well into next year. Many could argue that Trichet has moved the ECB closer to neutral by reminding traders that he did not say monetary policy was accommodative and on balance, the risk to growth is to the downside. However the fact that he refused to comment on the exchange rate meant that he is not particularly worried about the current price level in the pair. For currency traders, this was a green light for a move back towards the all time high of 1.4282.
[B]Will the ECB Intervene In the Euro?[/B]
If the Euro continues to rise, everyone will be wondering when the ECB will acknowledge the damaging impact of a strong Euro. European politicians and exporters have been expressing severe discontent with the current level of the currency. The last time that Trichet was concerned about the currency’s strength was back in 2004, when the EUR/USD was trading slightly above 1.36. Now that we are trading well above 1.40, it is surprising to many that the central bank has not expressed discontent. In late 2004, the EUR/USD topped out after Trichet called the move brutal so why has the ECB been so reluctant this time around? The most recent 2.1 percent flash estimate of consumer prices may be the reason. This is the first time in over a year that inflation rose above ECB’s 2 percent target. Even though the rising Euro is suppose to reduce inflationary pressures, the even stronger rise in commodity prices is offsetting that impact. Although there has been speculation of physical intervention, the latest comments from Trichet suggest that they would verbally intervene before physically doing so. Something will probably need to be done before the upcoming G7 meeting in Washington, which is scheduled for Oct 20-21. Many people believe that the G7 could crack down on Euro strength or dollar weakness.

Although the EUR/USD is currently in a clear uptrend, further gains beyond current levels could prove difficult. US economic data is beginning to show signs of strength while Eurozone data is beginning to show signs of weakness. If this trend continues and the US avoids falling into a recession, then the weakness that we have seen thus far in the dollar will be exactly what helps to turn the US economy around. At the same time, rate hikes have probably peaked in the Eurozone. Depending upon whether growth or inflation gets out of hand faster, the ECB may be forced to acknowledge the damaging impact of Euro strength, which could mark a true top in the EUR/USD.
[B]EURUSD Technical Outlook[/B]
Last quarter, we presented an alternate count in the event that our favored count, which has the EURUSD topping in an ending diagonal near 1.4000, proved wrong. We wrote that “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.” Sure enough, the alternate has proved correct. Near term, price may test or even slightly exceed 1.4281 but a larger setback is due, probably to the 1.3700-1.3800 area (1.3700 is the 61.8% of 1.3360-1.4281 and 1.3830 is the 4th wave of one less degree). The entire EURUSD rally from 1.2458 is suspicious because every top and bottom overlaps. In Elliott, overlapping waves is characteristic of a correction. Additionally, monthly RSI is in overbought territory and divergent with the highs made in 2003 and 2004. Recent COT readings show that less than 20% of all speculative positions are bullish. This phenomenon has happened just 5 times since 1990 (including this time) and each instance has led to a significant bottom. Markets can remain extreme for some time but there is plenty of evidence to support a reversal of significant proportion in the months ahead. Returning to the wave structure; if the entire rally from 1.2458 is a correction, then what is it a correction of? As we have detailed in previous forecasts, the decline from the December 2004 top at 1.3666 was a clear 5 wave decline. This decline could be wave A in a larger multi-year A-B-C flat correction. B waves of flat corrections often retrace 100% to 138% of wave A (and end beyond the origin of wave A). If indeed a multi-year flat correction is unfolding, then B = 138% of A at 1.4441. The structure of the rally from 1.1640 is a complex correction labeled W-X-Y. Wave Y from 1.2458 is a double zigzag. In summary, expect at least a return to 1.3700/1.3800 in the next few weeks with bullish potential to 1.4500 but strong evidence exists that the EURUSD is approaching a significant top. Follow the daily technicals for timely trade ideas.

[B]Written by DailyFX Research Team[/B]