Wednesday, September 19, 2007

EUR/USD - Be Careful What You Wish For

by Claus Vistesen

cross-posted from Alpha Sources

Financial market participants around the globe are eagerly anticipating today's Fed meeting which, according to an overwhelming consensus on expectations, will bring the Federal funds rate down to 5% from 5.25% or perhaps even to 4.75% although I have to say that this seems unlikely. However, apart from the immediate decision by the Fed as it appears today it has been very interesting I think to follow the somewhat change in the narrative on the Eur/Usd in the recent week. From Eurointelligence we heard recently how the Eur/Usd was approaching 1.40 (and it is!) and how financial market participants are changing their long term views on the US economy.

The big news yesterday was the fall in the dollar to another record low against the euro, breaking though $1.39, as investors are changing their fundamental views about the long-term prospects for the US currency.

Turning to the actual traded value of the Dollar we have indeed been seeing a steady decline of the Greenback as investors are lining up for a cut by Bernanke or was it a bail-out?

The dollar fell to within a half- cent of a record low against the euro as investors expect the Federal Reserve to cut interest rates today for the first time in four years.

Traders also sold dollars as U.S. producer prices fell more than forecast in August, diminishing concern over inflation. The Fed will probably cut the benchmark rate 25 basis points to support the economy, according to the median prediction of 134 economists surveyed by Bloomberg. Japan's currency dropped as gains in U.S. stocks encouraged traders to resume risky bets financed with borrowed yen. The dollar traded at $1.3873 per euro at 10 a.m. in New York [edit: today], from $1.3867 yesterday. The dollar reached a record low of $1.3927 per euro on Sept. 13 and has lost 4.9 percent this year. The U.S. currency also touched a 30-year low of 98.01 U.S. cents per Canadian dollar.

To top it all off the previous chairman of the Federal Reserve 'the Maestro himself' also added his opinion to the debate proclaiming that the Euro could very well be ready to take over the from the Dollar as the world's reserve currency. Greenspan is certainly poking all over the place at the moment and even though he does not hold de-facto leverage regarding anything in financial markets but still the current economic and financial market climate is seeing a lot of self-fulfilling prophecy mongering at the moment.

The euro could replace the U.S. dollar as the world's primary reserve currency, a German magazine quoted former Federal Reserve Chairman Alan Greenspan as saying on Monday. Greenspan told weekly Stern it was "absolutely conceivable that the euro will replace the dollar as reserve currency, or will be traded as an equally important reserve currency," the magazine said in a preview of this week's edition. The dollar no longer had much of a lead over the euro, he said, adding that the European Central Bank had "developed into a global economic force to be taken seriously."

So, it appears that it could well be game, set and match for the Dollar as the markets line up for the Fed to lower rates. For all intent and purposes I am going to leave most of my powder dry in this note since I am preparing a longer article on the widely debated topic of de-coupling which obviously is going to deal with this and other issue in more detail. Yet, let me still point out just a few salient points.

First of all, there can be no doubt that the Dollar indeed is and more importantly has been falling relative to the Euro as can be seen from the graph below.

In particularly, I would like that you note the time scale of the graph as it begins at the end of Q3 2006 which is exactly the point in time where the Fed went on hold whereas the ECB continued to thunder along. As such, the point I am trying to hammer down is that whatever change we might assign to the fundamentals of the global economy it could seem as if the EUR/USD has increasingly been driven by interest differentials and more importantly expectations of interest differentials. And the question then becomes what can we expect as we move further?

This would then bring us back to those famous fundamentals and in that respect I want to mention a couple of points which will be treated in more detail in my before mentioned note 'in preparation' on de-coupling. As such, to the extent that the EUR/USD is driven by interest differentials and expectations hereof how much can we expect the ECB and the FED to move in opposite direction? I mean, this must after all be the ultimate test of de-coupling and global rebalancing in a world where key Asian economies and the Petroexporters continues to peg (oh, and don't be talking to me about Japan who seems rather glad to finance the US even if Yields on US treasury bills seem set to go down). In this way we should never forget the ultimate thesis pointing to a correction of the global imbalances and thus the Dollar epitomized through the following quotes taken from a recent piece by Bloomberg;

``We are heading for a slow and steady easing cycle in the U.S.,'' said Michael Metcalfe, head of macro strategy at State Street Global Markets in London. ``If
interest-rate differentials return to drive currencies and the Fed is likely to ease relatively to other countries, there's a lot of capacity for dollar selling from institutional investors.''


The dollar may extend losses after Venezuelan President Hugo Chavez instructed Petroleos de Venezuela SA, the state oil company, to convert its investments from dollars to euros and Asian currencies to reduce risk. Chavez, speaking in his weekly address, said yesterday the U.S. has bought goods from around the world with paper that is `a bubble.''

Now, of course we shouldn't perhaps put too much into Chavez' threats of diversification into Euros as a proxy for a general trend but coupled with Michael Metcalfe's note about how institutional investors could just shed their Dollars we are of course looking at a scenario in which the Dollar peggers and in general those who finance the US external debt position steadily could diversify into Euros. This would of course entail a sharp depreciation of the Dollar relative to the Euro and subsequent bring with it, as per definition I would say, a de-coupling from the US economy and ultimately perhaps rebalancing. Yet, is this plausible and if so is this something which we would want at this point in time? Turning first to the former I would simply say no. However, I also need to realize that just because I perceive the fundamentals to be aligned in a particular way this does not mean that others share my views. In fact, it could seem as if many prominent commentators and market participants at the moment are set firmly in their belief that this just might be the time where the Euro took up the baton of the Dollar. This then brings me to the latter point regarding whether this would be a good idea. After all, isn't perhaps time for the US economy to correct those deficits? Well, I won't go into this here but in connection to the general question of whether the Euro should/can take up the slack of a Dollar correction (or the Yen for that matter) my answer is a resounding no! Quite simply I believe this is completely unfeasible in relation to the current markup of the Eurozone and especially countries such as Italy, Portugal, Greece and essentially also Germany would find it very hard to live with such a correction. In this way, we need to understand I believe that the expectations of closing (or perhaps widening) interest rate differentials and thus yields between the US and Eurozone economy are out of sync relative to what the ECB had to do in such a situation. In fact, I would already argue that given the Eurozone sub par performance clocked in Q2 the ECB is not very likely to continue its hiking trip.

Now, look at me. Here I go again to say way too much in what was supposed to be a short piece. In summary I would say that I don't see how the fundamentals have changed much in the global economy (i.e. we quite simply need the US external deficit) but my view is not the only one out there and things can indeed be set into motion on the expectation of a perceived change in global economic conditions. If this is the case be it as it may I still want to reiterate my headline; as such, be indeed careful what you wish for.

No comments: