As the EUR/USD hits new all time highs, the question facing the FX market in Q3 of 2007 is how high can it go? The latest wave of dollar selling has been triggered by the market?s disappointment with the Fed Chairman Ben Bernanke?s lack of focus on headline inflation as well as the possibility of a ratings downgrade on sub-prime bonds by Standard and Poor?s. A lower rating means not only a higher risk of default on the loans, but also higher interest rates.
With Adjustable Rate Mortgages already being re-priced at much higher levels, the fear is that consumers could become even more stretched if their monthly payments continue to rise in the months to come. Problems such as these will continue to keep the Federal Reserve on hold, which contrasts with the European Central Bank?s plans to increase interest rates at least once this year. The adjustment that we are seeing in the currency market over the past 24 hours represents an increase of risk. For the past month, the market has become complacent as the bulk of problems in sub-prime have not filtered into prime. However, the rise in the EURUSD to 1.40 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 should the projected rate hikes not materialize.
[B]US - Consumer Tapped Out[/B]
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 and 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 future forecast of US demand 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 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 for the US consumer 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.
[B]Housing - Becoming More Worrisome[/B]
The situation is further aggravated by the persistent slide in housing values and the growing problems in the sub-prime sector. The possible downgrade by Standard and Poor?s could cut the rating of 612 US sub-prime mortgage backed bonds, affecting $12 billion in residential mortgages. This comes at a time when the annualized rate of New Home Sales had also declined from 2MM units a year ago to barely 900K in the latest monthly survey. The pressure in housing is coming from two fronts - the nearly 1 Trillion dollars of repricing of adjustable rate mortgages due to occur in the next 12 months and the considerably more stringent credit terms from lenders which have thinned the pool of potential buyers, driving down property values. That in turn has significantly depressed the use of Mortgage Equity Withdrawal to finance household purchases which was formerly a very potent source of additional funds for US consumers.
[B]Manufacturing to the Rescue?[/B]
However, despite 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. ISM Manufacturing has improved from 49.7 reading at the start of the year to 56 by end the of June. A weaker dollar has certainly helped the industrial sector making US products more competitive especially against European counterparts. For now at least export growth has managed to offset some of the most negative effects of the implosion in housing. Furthermore, as long as the job cycle remains virtuous the greenback is in little danger of a collapse. Jobs provide incomes to service the key debt obligations of US consumers and fuel any marginal expenditure. Indeed the latest results from Retail Sales report which jumped 1.4% vs. 0.6% forecast, indicate that the US consumer is still willing to spend. In fact June?s reading was the best monthly performance in 18 months debunking the notion that the US economy is about to tip over into a recession.
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. Durable goods for the month of May contracted sharply by -2.8% vs. -1.0% expected, although this was the first negative result in 4 months. More ominously for future corporate production and consumer demand was the steep fall in auto sales for June. GM, for one 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 in more than 18 months. If these data points indicate a turn of trend in the industrial sector, they will negate the dollar bullish 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 will not be loosened 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]EUR at 1.40 - Likely But By No Means Guaranteed[/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 the consumer. 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 current 5.25% levels 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 far more hawkish posture from the European central bankers.
[B]Finally, From a Technical Perspective - A Top May be Near[/B]
According to our Technical Analyst Jamie Saettele, from a technical perspective a top may be near in the EUR/USD. Wave 5 within the 5 wave rally that began at 1.3261 is close to an end. The pair is pressing up against the resistance line drawn off of the 6/19 and 7/2 highs. In the very short term, the pair is tracing out a small wave 4 (within larger wave 5). The 5th of the 5th should exceed 1.3786, if only slightly, before a reversal.