Euro: The Return of History

The fall of the euro from the heights does not mean that traders have resigned from recent currency history. Even after its unprecedented fall, the united currency has only now returned to the middle of its rising trend against the dollar that has prevailed for six and a half years, since early 2002. Very little in the Eurozone economic situation or world economic history had warranted the euro’s presence north of 1.5500.

But nothing in the United States' present economic condition indicates that it has broken its long term disability against the euro. The Eurozone economies were never as immune to the sub prime contagion as dollar detractors proclaimed. And they have proven equally susceptible, if not more, to economic damage from high energy prices.

But neither is the United States bound to respond to 325 basis points of central bank rate reductions with its usual vigor and in the normal time frame of six months to a year. The old scenario which had the European Monetary Union [EMU] proceeding with moderate economic growth and a steady or hiking European Central Bank [ECB] paired with a recessionary America and an easing Federal Reserve has been abandoned. The new assumption has the benefit of initial proof, negative GDP in the Eurozone second quarter and positive US results, but it is essentially untested.

The American economy retains considerable known problems: the prolonged housing slump, the drag from gasoline and energy prices, the contraction of commercial credit; and several dangerous unknowns: the possibility of large failures in the financial system, a return to $140 or higher oil prices, and the degree to which the economy was bolstered by the Federal cash stimulus in the second quarter. Any one or a combination of these could easily derail what positive economic momentum exists in the US. There is also the uncertainty attached to the presidential election and the candidates’ competing and quite different economic prescriptions. The proposed economic plans of each party stress voter friendly initiatives; few will be good for the dollar.

The ECB governors seem a bit surprised that mundane economic reality still applies to them. It was a scant three months ago when government and central bank officials were proclaiming their expectations for continued moderate economic growth in 2008.

The Europeans have their share of problems as well. If the two major countries, Germany and France, are not suffering the aftermath of a real estate bubble, that is not true of some of the smaller members, primarily Spain and Ireland. Energy costs are as great a drag on economic well being as they are in the States and they certainly have a greater effect on consumer outlook and spending. Russia, newly assertive and unmistakably threatening, sits astride European energy supplies, supplies for which there are no domestic alternatives. Finally any worldwide financial catastrophes will leave casualties in Europe, Asia, and America equally.

The change in economic outlook in the EMU has been enough to boost the dollar substantially as it put paid to unrealistic expectations for European autarky.

It is now the US economy that is expected to sustain a recovery first, or at least to grow faster than its European counterpart. Neither central bank is in a position to change its rate policy.

The ECB is constrained by inflation, its own rhetorical history, and institutional credibility. The members of the ECB governing board and President Trichet are intelligent, analytical and persuasive individuals. In setting a public inflation target they and their predecessors had to have known that a time might come when they would be forced to choose between inflation control and economic growth. That time is now. If the pending recession, which Trichet warned about six weeks ago, could not prompt an adjustment of ECB policy, another quarter of negative growth will not do so.

Likewise, the Federal Reserve cannot raise rates to combat 5.6% inflation. The US economy is weak, 2nd quarter GDP notwithstanding, with glaring vulnerabilities in finance and energy costs. For the next few months central bank rate policy is not likely to be the determining factor in the relation between the euro and the dollar.

The debunking of one unrealistic assumption in Europe does not mean another, almost equally unrealistic, the return of the US to robust growth, is about to happen. From November until February the market traded back and forth between 1.4400 and 1.4900. That is precisely the position now. A prolonged muddle could be ahead while traders wait for statistics to resolve their questions. The dollar run is not over, but its continuation will require further proof. An extension of dollar strength will have to go quite a bit further, to below 1.4000, before its six year fall against the euro can be broken. That is not a project that will be completed in the next few months.

Comments

[bruin532:]

The ability of the US economy to rebound quickly (before Europe)because it was first in so its first out of recession is no given. The systemic problems of debt, entitlements, bailouts, jobs do not bode well for a quick let alone robust recovery.

2008 Aug 25 06:58 AM

[phdinsuntan...:]

2 dolars / euro is on the way, just compare wher US M3 is expected in 2009, and gold @ 2000

2008 Aug 25 08:44 AM

[notsosmart:]

history does not apply to current situations.its a "new" world order.nobody really knows anything about anything.charts,graphs... ask bear stearn employees(ex) what their opinion was of our financial system while their ceo was busy at bridge contests.get my point.

2008 Aug 25 10:52 AM

[carey_jim:]

You've forgotten one thing: A stronger dollar might help the United States economy.

Economic expediency is a "fundamental" that often trumps so-called economic and financial fundamental laws.

If the "authorities" and their shark friends in the currency pits think a strong dollar will be better for the United States and possibly for the rest of the world, well then us financial piranha fish alpha speculators will start to short the Euro too.

It's that simple. Economic fundamentals? What relevance have they ever had?

2008 Aug 25 12:20 PM