Dollar weakness hit a new extreme in the first quarter of 2008 as the greenback fell within an arm’s reach of 1.60 against the Euro and 95 against the Japanese Yen. Interest rate cuts by the Federal Reserve have turned the US dollar into the second lowest yielding currency in the developed world. Since then, the dollar has recovered from its March lows, leaving many traders wondering whether the greenback has hit a bottom. Interestingly enough, the outlook for the US economy has actually worsened with US non-farm payrolls falling for the third consecutive month. Given this deterioration, how can the US dollar strengthen and furthermore, can this rally turn into a more significant recovery?
[B]Unprecedented Developments Trigger Unprecedented Responses[/B]
Over the past 3 months, the Federal Reserve has taken unprecedented measures to restore stability in the US financial system. The collapse of Bear Stearns, which was once the nation’s 5th largest investment bank, put the 2007 / 2008 financial crisis into the history books. This was the first time since the Great Depression that a major US bank has failed. In response to the groundbreaking crisis, the Federal Reserve invoked an emergency provision allowing the central bank to loan directly to investment banks. This provision was added to the Federal Reserve Act during the Great Depression and has not been used since then. However the collapse of a major US bank and tight credit markets are making the Federal Reserve’s job exceptionally difficult. Cutting interest rates alone has not worked and as a result, the US central bank has introduced an alphabet soup of new measures, including the Term Auction Facility and the Term Securities Lending Facility to inject liquidity into the financial system. They are even willing to accept less liquid and dubious mortgage backed securities for the Fed’s highly liquid and rock solid US Treasuries.
Although these efforts have prevented a collapse in the equity markets, it has not prevented a continual deterioration in the US economy. With foreclosures on the rise and the median price of existing homes falling by largest amount on record in February, the housing market shows no signs of stabilization. Layoffs are on the rise and consumer spending is contracting, which has forced the Federal Reserve to cut interest rates by 200bp in the first quarter, the most that the central bank has cut in one quarter since 1984. The combination of a deteriorating outlook for the US economy, lower interest rates and desperate measures by the Federal Reserve are the main reasons why the US dollar hit a record low in March.
A continual recovery in the dollar will depend on one of two things (or both):
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The degree of Interest Rate Cuts from the Federal Reserve -
Slowdown in the Eurozone Economy
[B]How Low Will the Fed Go?[/B]
We expect the Federal Reserve to continue cutting interest rates because the US economy will deteriorate further. The labor market alone is enough reason for the Fed to bring rates down to 1.50 percent. Dell and Motorola joined ATA and Aloha Airlines in announcing more layoffs. These 4 companies alone will shave 14k from the US workforce. Over the past 3 decades, the US economy has gone through 3 recessions. During those times, a string of job losses lasted for a minimum of 10 months and we are already beginning to see the same trend unfold. It will be months before the US economy begins creating jobs once again. The largest single month job loss in each of the prior three recessions was more than 300k. So why should it be any different this time around? We would not be surprised to see the same severity of job losses in this business cycle. If NFPs print -100k, the markets will be rushing to price in 1.50 percent rates. As for retail sales, they should continue to suffer as well. Linens ‘n Things have just joined Domain, Fortunoff, and Sharper Image in filing for bankruptcy protection. Other companies like Foot Locker have closed many of its stores and are expected to shut down even more in the coming year.
[B]What About Inflation?[/B]
Another 75bp is probably the best that we will get from the US central bank because at some point, they will no longer be able to turn a blind eye to inflation. According to the March 18 FOMC minutes, two of the Fed Presidents expressed strong concern about heightened inflation risks and favored easing policy less aggressively than the 75bp that the Fed actually delivered. They believe that it takes time for rate cuts to be felt in the economy and that they cannot wait for evidence of inflation sticking, as by then it would be too late to prevent a further increase.
Interest rate cuts alone will not do the trick and for this reason, the Federal Reserve needs to focus on other measures targeted at relieving liquidity strains. Slowing down or putting an end to rate cuts may be exactly what the US dollar needs to recover. Going forward, we expect more creativity from the Federal Reserve because short of printing money, the size of the Federal Reserve’s balance sheet will limit what they can do. In the middle of March, the Fed committed to swap 60% ($420 billion) of its $700 billion balance sheet of US Treasuries for mortgage backed securities. Recently there have been reports that the Fed is eyeing the Nordic-Style nationalization of US banks as a temporary solution to the US financial crisis. Printing money in the current market environment is not a likely option because it would foster even stronger inflationary pressures.
The second factor that could turn the dollar around would be a sharp slowdown in the Eurozone economy. This is discussed further in the Q2 outlook for the Eurozone, but recoupling in the fourth quarter of 2008 could play a big role in the dollar’s recovery. The ripple effects of the US subprime crisis have impacted many countries and chinks in the armor are beginning to show in the Eurozone despite the central bank’s persistently hawkish monetary policy stance. Eventually, the ECB will be forced to cut interest rates and at that time they will most likely find themselves behind the curve. This will result in an interesting twist of fate where the ECB begins to cut interest rates at a time when the Federal Reserve is done.
[B]US: How Deep of a Recession?[/B]
Debating whether or not the US economy has fallen into a recession is now a mute point because for most Americans already fell like the US economy is in a recession. Growth in the fourth quarter was a mere 0.4 percent and growth in the first quarter could be even worse. Two weeks ago, for the first time in this business cycle, Fed Chairman Ben Bernanke said the US economy could fall into a recession when he testified before the Joint Economic Committee. Until now, every member of the Bush Administration has avoided the word like the plague. The only question is how deep of a recession will we see? The central bank is throwing everything but the kitchen sink at the markets and we believe that they will begin to see the fruits of the labor in the fourth quarter. A lot of money is still parked on the sidelines waiting for a buying opportunity. Foreigners have come in to snap up US real estate, providing a buffer for the ailing housing market. The same thing is happening in US stocks and we believe that this could exacerbate on the first signs of stabilization in the US economy. Therefore even though Q2 could mean more dollar weakness, the dollar should begin to recover in the second half of the year.
[B]Euro the Invincible[/B]
One of the more amazing feats of the Eurozone economy in Q1 of 2008 was its ability to compete and grow despite the twin obstacles of slowing North American market and the ever rising exchange rate which created massive cost disadvantages for the export driven region. One key piece of evidence supporting this point of view was the latest reading of the IFO survey of business sentiment which printed a much stronger 104.8 versus expectations of 103.5. The report suggested that at least for the moment the economy in the 17 nation union continues to operate at a healthy pace irrespective of the troubles in US.
The boom in EZ was led by the export sector, most notably in Germany as gains in efficiency coupled with strong demand from emerging markets, have helped producers in metal, electronics and car industries to create more jobs at the start of the year than at any time in the past four decades.
[B]ECB Remained Hawkish As Employment Growth Continued[/B]
Little wonder then that the ECB has remained hawkish throughout the first quarter of 2008 feeling no particular pressure to ease rates any time soon. The net result was that Eurozone rates have remained steady at 4% while the Fed funds rate declined to 2.25% creating a 175 basis point interest rate differential in favor of the single currency.
One of the key reasons for ECB’s staunch hawkishness has been the relatively buoyant labor picture. German unemployment continued to decline each month during the quarter while French unemployment reached a 20 year low. We have long contended that the ECB will not change its hawkish posture until and unless demand for labor in the region begins to contract. The strong IFO results which were supportive of continued expansion in employment indicate that Mr. Trichet and company will not be in any hurry to change their policy course anytime soon.
[B]Clouds on the Horizon[/B]
However, as the quarter came to an end, evidence of slowdown in the region began to appear in the data and the vaunted decoupling scenario which supported euro bulls all through the Q1 rally was starting to come apart at the seams. Most notable was the very steep decline in EZ retail sales which for the month of February declined by –0.5% versus consensus calls of 0.2% gain. The sharp fall-off was led by the region’s most important economy – Germany, which saw retail sales contract –1.7% on a month over month basis. Given the strength in employment and the high value of the euro, such a large decrease caught many market participants by surprise, suggesting that EZ economy may be weaker than it seems. Indeed, with the consumer unwilling to spend, the regions’ growth is likely to depend even more on the growth of its producers and given the fact that global expansion is beginning to slow, such dependence on the export sector may prove to be highly problematic.
[B]North – South Decoupling?[/B]
Furthermore, growth in the EZ is not uniform, but rather highly divided between northern and southern parts of the region. The latest Retail PMI report showed deterioration across the board but the reading from Italy was particularly bad printing at 36.4 – the worst level since the survey began. Italy remains the weakest link amongst the top 3 EZ economies and if the situation there deteriorates further political tensions in the region could begin to undermine euro’s seemingly relentless rise as the interests of Italy, Spain and other southern European members could come in conflict with those of France and Germany where growth continues at a reasonable pace. Decoupling may continue to be the theme in Q2, but this time decoupling will refer to the story of divergence within EZ itself rather than the more common notion of growth rate differentials between US and EZ economies.
[B]Euro Strength Will Only Come From Dollar’s Weakness [/B]
In Q1 euro strength was driven by surprisingly strong fundamentals as the region continued to grow and expand despite having to battle higher exchange rates, higher interest rates and the effects of slowdown in North America caused by the credit crisis in asset backed securities. However as the quarter came to a close, the slowdown in demand was becoming evident in the EZ as well. Therefore going forward, the data from the region is unlikely to prove as fundamentally supportive as it was during Q1 of 2008. As global demand cools and the after effects of the financial crisis begin to afflict EZ economies, the euro will no longer benefit from diverging interest rate trends. At best EZ interest rates will remain stationary at 4% and may even begin to ease as the year progresses. Under such a scenario much of the momentum for the euro long positions will be gone and the unit will only rise on anti-dollar sentiment alone. To that end the upside in the pair will be determined by further deterioration of US data, most particularly the contraction in US jobs. With consumer credit at record highs, US could experience a serious recession if unemployment skyrockets and incomes drop severely handicapping the ability of US consumers to service their debts. US rates will likely fall further widening the interest rate differential in the pair and propelling euro higher.
I[B]ntervention Beyond 1.60?[/B]
However, even if the EURUSD rises, how much further can it go before attracting the interest of monetary authorities? At 1.60 the Europeans and especially the French are likely to become quite concerned about the strength of the currency. Already the French Finance Minister Christine Lagarade noted that, “'We have acknowledged that we are suffering together from the excessive volatility of exchange rates among all currencies,” adding that there is a “need to obtain adjustments, if possible.” While any talk of central bank intervention is clearly premature, it is important to note that last time EURUSD appreciated approximately 12% in a near uninterrupted fashion in 2004, ECB chief Jean Claude Trichet noted that the moves were “brutal” and the EURUSD immediately declined 600 points as result. So far the ECB officials have stayed away from such dramatic rhetoric, however should the EURUSD catapult to approximately 1.6200 it will have appreciated about 12% in the most recent rally. At that time the laissez faire attitude of ECB officials may change and their rhetoric is likely to become much more aggressive as they try to contain any further appreciation in the currency.
[B]Key Points[/B]
As currency markets look ahead to Q2 of 2008, the picture for the EUR/USD looks far more precarious than it did at the start of the year. For the time being the unit remains in a strong uptrend against the greenback enjoying a substantial interest rate differential in its favor. However, clear signs of slowing economic growth in the region and the vast disparity in performance between Northern and Southern nations of the European Union are likely to create more tensions as we move ahead. So far, the region has been able to absorb the brunt of the exchange rate adjustments and continue to grow despite the headwinds of unfavorable exchange rates. However, should the unit appreciate much beyond the 1.6000 level, ECB monetary officials are unlikely to remain so nonchalant about the strength of the currency as the combination of slowing global economic growth along with persistently high exchange rate will inevitably cause a decline in labor demand, putting enormous political pressure on the ECB to ease monetary policy. Further upside in the euro therefore is likely to come only from additional anti-dollar sentiment rather than from any organic strength of it own and that upside is likely to be curbed by actions of EZ monetary officials who will become quite concerned if the unit trades much above the 1.60 level.
<strong style=""><u>EUR/USD Technical Outlook</em>
Last quarter, we wrote that “COT data supports an aggressive bullish bias over the next few weeks (at least) as both Euro bearish sentiment extremes and USD bullish sentiment extremes have recently been registered. This rally could extend towards 1.6000. Currencies have a tendency to sport 5th wave extensions which is consistent with a blow-off top, which happens so often in the currency and commodity markets.” Wave v of 3 ended up breaking higher from a triangle and the advance is either over just above 1.59 or an ending diagonal is underway from 1.5342. In the former scenario, the EURUSD is expected to come below 1.5342 in a wave 4 correction and reach the 38.2% of 1.3261-1.5904 at 1.4894. If the diagonal scenario plays out, then the EURUSD will rally a bit higher but in a choppy manner before declining in the mentioned 4th wave. In summary, risk is to the downside.
