The New Paradigm of the World Economy

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As the financial crisis is expanding globally, the state of the U.S. economy might remain weak for most of 2009. Housing has not shown a bottom yet and consumption could deteriorate further. The U.S. dollar short/medium term trend stays bullish, but the longer term picture might contemplate new lows against world currencies.

New Leaders Wanted

The concentric work done by the U.S. Treasury and the Federal Reserve requires time to get fully into the economic system, although more work needs to be done to restore confidence and allow businesses to create new jobs again. In effect, households have to repay debts and the financial sector must increase reserves. So, with the unemployment rate rising and the inflation softening, the Federal Reserve is preparing another rate cut by 50/25 basis points. In addition, a new fiscal stimulus package is a possible solution, albeit not probable, while the Fed might buy Treasury bonds in an effort to increase its balance sheet.

Will it be enough? Yes and no. As opposed to the past, the current crisis is systemic. It includes both the real economy and the financial sector. As a result, a different paradigm, a new frame of reference from which the world is seen, might be necessary for policymakers to face the challenges of the new era. A creative set of values should be brought to the table by a fresh generation of leaders. This will be one of the most challenging and rewarding tasks for the new president of the United States.

We are probably living in one of the more, if not the most, challenging periods of the past four decades. In September, the U.S. industrial production slumped 2.8% month on month, the worst monthly decline of the past thirty-four years, after sliding 1.0% in August. The down move was broad based with business equipment falling 7.0%, the largest drop in sixty-one years, and mining sliding almost 8.0%. The only bright spot was inflation, since capacity utilization moved to 76.4% from 78.7%. In reality, commodity prices will keep on falling over the short/medium term, along with a receding economic growth.

In September, the Consumer Price Index (CPI) was unchanged month on month, but ticked down to 4.9% year on year from 5.4%. During the same period, the Producer Price Index (PPI) declined 0.4% on the top of the down move of August (-0.9%). Annually, the PPI is now at 8.7% from 9.6%. Nevertheless, the long term trend stays strongly bullish for all commodities and new highs will discovered, once the economic slowdown will subside.

How long will the U.S. dollar trend higher?

How will the U.S. dollar perform in the current reality? The greenback maintains a competitive advantage over those countries that have not acted promptly to the financial crisis. The financial turmoil, which began in the United States, has now decisively jumped the fence and is running into the European territory. The British government anticipated a partial nationalization of the banking sectors and the European Union (E.U.) finally found a series of guidelines to rescue the unstable financial system. It is better now than never, but the economic contraction is widespread in most activities such as investments, households and trade.

ECB officials are now targeting growth over inflation as the main priority. Consequently, a new set of rate cuts are possible between now and the first months of 2009. Nonetheless, the long period of inaction will postpone the end the crisis further into the future, since consumption is falling and employment is receding. In the second quarter, the final Euro zone Gross Domestic Product (GDP) slid 0.2% quarter-on-quarter and increased only 1.4% on an annual basis, after rising 2.1% in the first quarter. As a result, the European currency should remain under pressure for now. However, the long term picture seems to anticipate more strength ahead for the Euro against greenback, if history repeats itself. Let us see why.

Since 1972, the Euro currency (previously the D-Mark) showed two majors up move against the U.S. dollar. One began in 1972 and ended in 1980 (8 years). The other started in 1985 and finished in 1995 (10 years). Within the long term up trends, the Euro/Usd corrected about six times from the highs. The bearish corrections extended for about 15%-20% from top to bottoms.

The declines lasted between 5 and 18 months (1973-08 - 1974-01, 1975-02 - 1975-12, 1987-12 - 1989-06, 1991-02 - 1991-07, 1992-09 - 1994-02) before the up trend resumed its course.

What can investors expect in the coming months? The current long term trend initiated around 2001 and topped for the first time in 2004-12 and the second up leg ended in July 2008 at around 1.60. As a result, we are entering into the crucial area around 1.28/1.26, which represents a 20% decline from the top, albeit still away from the 5/18 corrective months manifested during the previous two long term bullish cycles.

Disclosure: No position.