Dollar and Euro: Different Week, Same Drivers

It has been a very volatile week for the US dollar, even though compared to the beginning of the week, the exchange rate for the EUR/USD and USD/JPY has remained virtually unchanged.

On Monday, the EUR/USD was trading at 1.5922 while USD/JPY was trading at 106.26, not far from current levels, but of course these rates masks what can only be likened to a rollercoaster ride in the financial markets. There were a number of event risks and economic data released over the past week, yet the drivers of the financial market volatility can be boiled down to 2 things: the health of the financial sector and oil prices.

We have come a long way since traders first speculated about the possible demise of Fannie Mae (FNM) and Freddie Mac (FRE). The Federal Reserve and the Treasury have offered different solutions to avert more serious problems, while Freddie Mac has announced plans to raise capital by selling as much as $10 billion in new shares to investors. Based upon the 600 point recovery in the Dow off of Tuesday’s intraday low, for the time being traders believe that this could be enough.

JPMorgan (JPM) and Citigroup (C) have reported better than expected earnings even though Merrill Lynch (MER) disappointed; 2 out of 3 appears to keep the markets happy for the time being. As for economic data, we learned that inflation remains hot but consumer spending is beginning to falter.

With the US economic calendar considerably lighter next week, the health of the financial sector, oil and the stock market will continue to set the tone for the FX markets. Earnings season is in full swing. Bank of America (BAC) will be releasing their earnings report on Monday and for the rest of the week there will be a number of regional banks reporting. Leading indicators, durable goods, the final July UMich consumer confidence numbers, new and existing home sales are due for release along with the Federal Reserve’s Beige Book report. We will be keeping a particular close eye on the Beige Book report because it will serve as a temperature gauge for how the US economy is really doing and how businesses and consumers may coping with the latest developments in the stock and commodity markets.

Eurozone Economy Continues to Slow

The Euro is consolidating near its all-time highs against the US dollar, even though we are reminded on a near daily basis about the risks to Eurozone growth. Last night I was having dinner with a businessman from France and he described to me the sour mood in Europe. He indicated that businesses are growing very pessimistic, which confirms that Europeans are tightening their belts as they learn to deal with high prices. This conversation comes at a perfect time because the marquee release on the Eurozone calendar next week is the German IFO report of business confidence. Like the ZEW survey of analyst confidence, business confidence should have deteriorated materially over the past month. Not only did the European Central Bank raise interest rates for the first time since June 2007, but exports, factory orders and industrial production have also plummeted which confirms that business activity has dropped significantly.

The only wrinkle to this outlook was the sharp rebound in German retail sales, but we think that this should be a moot point since higher energy prices was a big reason for the increase in spending. Even though German producer prices grew by more than expected in June, the Eurozone trade deficit deteriorated materially in May, which came as a big surprise to the market.

Comments

[mkhanarian]

Hello, what are your thoughts on remarks from the Fed's Stern, when he stated that a rate rise can not wait until a recovery in the housing markets? While I agree that much of movements in the FX market is oil and earnings driven, the speculation on future interest rates is still central as well. While some believe Bernanke will cave to the pangs of inflation and follow the path of his European counterpart, this is not a certainty. What are your thoughts on the spread between the Fed Funds and Eurozone rates?

Cheers
MK

[Coelacanth]

Stern is a well known inflation hawk so I don't think anyone was surprised by his comments. As such I think the markets discounted what he said to some degree.

I haven't checked futures lately but I think most traders don't expect the Fed to hike rates this year in the U.S.

Interestingly....the tact most G-7's seem to be taking now is "we're leaving rates on hold expecting slowing growth to reign in inflation in the medium term".

Even though euro-zone & German PPI came in hot last week Trichet has said that he's willing to tolerate a flaring up of inflation in the short-term to see it moderate by next year. Unless inflation gets really out of hand in the coming months I don't expect this to change.

On Friday, futures markets should market participants expect a 78% chance the ECB will hike again this year vs. 55% last week. The change came on the heels of Trichet sounding a bit hawkish after Germany released their PPI numbers. I think the markets are reading too much into this. IMO there is no material difference between "we have no bias at this time" and "we may need future rate hikes".