There’s No Stopping the Powerful Euro

We have long been bullish of the Euro against both the Sterling and the Dollar. Their longterm patterns have been demanding long Euro positions since December 2007 (v the British Pound) and last September 2007 (v the Dollar). The problem has been timing: getting long in the short-term. But now we think the time is ripe - in both cases.

click charts to enlarge

We are already long the Euro in our Key Trades portfolio.

The Macro Trader’s View

After several months of frustrating range-trading, currency markets have finally received the short-term trigger they need to reconnect with their underlying long-term trend. In the Euro zone, data has begun to weaken over recent months and has led the ECB to abandon previous plans for higher rates, even though Euro zone inflation stands currently at 3.2% and risks moving higher.

The ECB recognize this risk, which is mainly driven by higher oil prices and dearer food prices - a problem that looks likely to exert further upward pressure on inflation over the coming months - but they now judge that the downside risks to growth outweigh those concerns and have hinted that interest rates could soon ease to help support the economy. However, compared to the US and even the UK, the Euro zone still looks the best of the bunch, with German IFO released earlier this week coming in at a stronger than expected 104.1.

In the UK, growth is expected to slow this year led by a housing market correction and an expected consumer slowdown:

The housing market correction is clearly underway, with only its severity up for debate, But the consumer, for now, refuses to lie down (as evidenced by last week’s stronger than expected retail sales report, although these were likely driven by deep discounts).

This has led the Bank of England to believe it will only need to ease policy minimally; 2 x 25bp rate cuts by year end as the MPC are still more concerned about the path of inflation, at least over the short term.

But over in the US, the origin of most of the global economy’s current woes, the picture is becoming bleaker:

The latest GDP data; Q4 was only 0.6% on an annualised basis, given the margin for error that could easily be flat.

The housing market continues to slump with little end in sight, Bond insurers remain in need of additional capital, although several have had their credit ratings affirmed.

The Labour market is looking increasingly weak as jobless claims are starting to gyrate towards the 375k level.

This has led the Fed to aggressively cut interest rates, and only this week Bernanke has indicated the Fed can and will do more. The Dollar has weakened on this news as inflation remains a problem, which US policy-makers acknowledge, but for now are unable to tackle as they seek to support growth; but given the downside risks to the economy, their fingers are crossed that inflation pressures will gradually abate.

The market is not in a generous mood and talk of stagflation in the US abounds and renders the Dollar weakened.

The main beneficiary in all of this is the Euro. Even though the Bank of England is taking a tougher stance on inflation than the Fed, traders judge the MPC will make the same error it made in summer 2007:

1. Failed to appreciate the severity of the liquidity crisis

2. Acted too late.

This time they are failing to recognize that a weakening economy, driven by a housing market correction, will be a powerful force bearing down on inflation; by the time they realize their error, policy makers will be way behind the curve and desperate to catch up.

In summary, the Euro looks the stronger option of the three.

Comments

[Freddy L]

Well if you look at the "Big Mac" index and other indicators as such, one would see that the Euro is overvalued at this point. Even if EUeconomic indicators are better than the US, the fact remains that most of the movement here has been due to carry trade, speculation, fear etc etc. I'm not saying the dollar is going to continue to lose value against the Euro, i'm just saying it isn't being driven by fundamentals right now, IMHO.

[01GTvert]

Anyone have an idea as to how high the euro can go VS the dollar? is 2:1 out of the question?

[fab]

when Tricher will finally understand that Europe is in a recession it will be too late. And the Euro will sink.

[ballsschweaty]

Europe is still an economic basket case like they have been for the last 25 years.