The Euro has reached unprecedented highs against the US Dollar in recent weeks. On April 22nd, the pair set an all-time high at 1.6018. The very next day, the 28-month rally that had taken the pair to such dizzying heights seemed over. The next two weeks would see the pair plummet 4.3% to trade just below 1.5300. While it seems that momentum to reach a historic level at 1.60 carried the pair along the last leg the rally, elation must now give way to a sober re-examination of the arguments for the Euro’s strength. Below we will discuss what triggered the Euro rally against the US dollar, and why it must now come to an end.
[B]
The Euro Rallies as Investors Flee US Markets[/B]
As pieces of non-performing subprime debt was discovered on the balance sheets of major banks and hedge funds, investors fled from equities to park their assets in commodities as a “store of value” and stock markets fell. Consumer and business confidence collapsed. Firms stopped hiring, consumers put off purchases, and economic growth deteriorated. By 2008, media outlets and presidential candidates alike shifted focus from overseas conflicts to the apparent onset of recession.
Initially, many investors entertained a “decoupling” hypothesis that suggested a US recession will not drag down global growth. This premise rested on the hope that lagging American demand will be replaced with robust consumption in emerging markets such as China and India. The Euro was a natural beneficiary - proponents of decoupling pointed to resilient European trade figures, saying the continent was immune because export growth had remained strong all the while the US consumer suffered. Boasting the most developed capital markets after the US, Europe looked like an attractive destination for investors looking to weather the US downturn. The Federal Reserve cut interest rates, tipping the yield gap to favor the Euro. Traders broadly sold dollar-denominated assets and bought Euros, fueling a spectacular rally in the EURUSD exchange rate (see Figure 1).
[B]
Economic Slowdown Extends to the Euro Zone[/B]
Most recent economic data has not been supportive of the decoupling world view. In particular, Euro Zone economic fundamentals have started to turn significantly lower (see Figure 2). Firms have faced a notable increase in production costs due to the rally in commodities (and energy in particular), with the most recent Producer Price Indices all posting gains. Interestingly, these increases are apparently not being passed on to consumers, with April’s CPI readings registering lower. Rather, slumping manufacturing figures and a brooding gloom in business sentiment readings suggest these costs are being absorbed into firms’ balance sheets. The strong Euro has depressed exports, with both Germany and France showing deterioration in Trade Balance figures in March. While unemployment has remained steady for now, it seems only a matter of time before the strain on businesses turns into layoffs. This will reduce wages, lower disposable income, and trim consumption. In fact, Europeans are already starting to cut back on expenses in anticipation of a leaner period as retail activity metrics have dropped decidedly into the red.
Structurally, the Euro Zone remains untested in a real economic crisis. Monetary union had not existed during the oil-driven shocks of the 1970s and EU member states were free to pursue individual objectives for interest rate policy. With adequate convergence between member states’ economies still in the realm of wishful thinking, the ECB will find it profoundly difficult to tailor a single monetary policy to accommodate everyone.
[B]ECB Rate Cuts Are Just Around the Corner[/B]
Still, the ECB is closer to cutting interest rates than they are willing to admit. ECB President Jean-Claude Trichet has made every effort to sound hawkish, saying that inflation would remain the bank’s “highest priority”. Should inflation begin to abate as growth slows, the ECB will be out of excuses. As shown above, Germany’s April CPI dropped from 3.1% to 2.4%, putting it at a 10-month low and in close proximity to the ECB’s target of 2%. The CPI reading for the entire Euro Zone declined as well, suggesting the bank will soon be able to shift gears towards looser monetary policy.
Credit markets appear to be of the same opinion. A look at how the yield curve has changed in the year to May reflects a shift towards expectations of a rate cut (see Figure 3). Each curve plots the yields for bonds of various maturities. In 2007, the curve looks normal – yields on short-term bonds are smaller than long-term ones. This makes sense because there is more uncertainty in buying a bond that will pay out in 10 years than a bond that will pay out in 1 year. To compensate for the extra risk, long-term bonds pay out greater yields. Currently, the curve looks inverted – yields on bonds with less than a year maturity are higher than those that mature in 1-2 years. If interest payouts are better now than in a year, the yield curve must suggest that rate cuts are being priced into the market.
[B]US Policy Makers Have Acted Decisively To Avoid Recession[/B]
Meanwhile across the Atlantic, American monetary and fiscal authorities have moved aggressively to fight off the specter of recession:
1. The Federal Reserve has slashed interest rates by 62% since September 2007
2. The Term Action Facility (TAF) has been used to provide hundreds of billions of dollars in short-term loans to banks.
3. Congress passed the Economic Stimulus Act of 2008, a fiscal stimulus package worth $168 billion.
US fundamentals are already starting to show the effects of these efforts (see Figure 4). While localized business sentiment reports are still in the red, the more critical national ISM survey has stabilized in its gauge of manufacturing outlook and showed improvement in the services sector. The falling US dollar has helped to boost export profits, improving earnings and rekindling an interest in US financial assets. To that effect, the trade deficit has contracted and TIC capital inflows increased enough to easily finance the shortfall. The housing market remains weak, so the consumer is understandably pessimistic. However, it is reasonable to think that the nascent stabilization has simply not reached the consumer via improved labor conditions yet. Should the uptick in manufacturing via strong Durable Goods Orders and the slowdown in the pace of job loss by nearly three quarters in April’s Nonfarm Payrolls signal a lasting reversal, the consumer will see normalization. Growth itself has remained stable, with first quarter GDP expanding at a steady 0.6%.
Most importantly, the Fed’s last interest rate cut from 2.25% to 2% was accompanied by a statement saying that monetary easing has been “substantial” while “energy and other commodity prices have increased and some indicators of inflation expectations have risen in recent months.” Further, the now familiar phrase warning that “downside risks to growth remain" had been removed. The change in wording comes courtesy of a recent uptick in core inflation. This suggests the Fed is shifting focus from economic growth to inflation, with a pause in monetary easing likely in the near term. Should a Fed pause come in close proximity to the start of easing globally (as seems to be the case), expectations of a tightening yield gap will favor the US dollar.
[B]The Case for Extended Weakness in the EURUSD[/B]
As we have discussed above, the Euro embarked on an unprecedented rally against the Dollar as traders desperate for a refuge destination to protect their assets from US meltdown poured money into the single currency. It has now become apparent that the Euro is not the safe heaven it was hoped to be – the slowdown has spread and Euro Zone fundamentals have started to weaken. Therefore, it makes sense to think that the EURUSD exchange rate must adjust to reflect where the crisis will end first rather than where it is and where it isn’t. America’s head start in dealing with the current malaise will mean it is likely to lead in the recovery as the Euro Zone lags behind. As traders continue to price in these developments, the EURUSD will continue to fall.
The technical picture supports this view. Following a speedy run from above 1.4430 to 1.60 in the first quarter, the EURUSD has collapsed. Having reached the historic high on the back of building momentum in preceding weeks, the pair failed to close above it, changing gears overnight as the sporting interest of reaching 1.60 faded. The very next day, EURUSD showed a large Bearish Reversal candlestick pattern and broke the dominant trend line the day after that. Fibonacci analysis shows the pair consolidating recent losses between the 23.6% and 38.2% retracements of the preceding up move (see Figure 5). From here, bearish momentum targets the 50% Fibonacci level at 1.5170. Given the deeply entrenched downward bias courtesy of shaping fundamental trends, the pair looks poised to surpass support, with the rally base above 1.4430 quickly following a break past 1.50.
[B]
[/B]
[I]To contact Ilya regarding or other articles he has authored, please emai him at <[email protected]>[/I]