Selling US dollars was one of the best trades of 2007. Since the beginning of the year, the dollar has fallen as much as 13 percent against the Euro, 10 percent against the Japanese Yen and 8.5 percent against the British pound. The story of the dollar’s weakness also captured headlines around the world. It became so pronounced that supermodel Gisele announced her preference for being paid in Euros over dollars while rapper Jay-Z flashed Euros and not dollars in his new music video. Everyone from our barbers to our bartenders has been asking us when the US dollar will bottom and just when that happened – the dollar’s slide came to a screeching halt. The question now is will the turn in the dollar last or will the weakness resume in the coming year?
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Recoupling Could Mean the End to Dollar Weakness
Before exploring the outlook for the US dollar in 2008, it is important to understand that decoupling in the global economy was a primary factor for the dollar’s weakness in 2007. As US growth slowed, growth in the rest of the world remained resilient thanks to the demand from countries like China, India and the Middle East. When the US began to ease interest rates in August, many central banks in countries such like Australia continued to raise rates since growth was steady enough for them to focus on tackling inflation. In fact, up until the Bank of England’s and Bank of Canada’s interest rate cut in December, the US was the only central bank to cut interest rates in 2007. This decoupling of growth was one of the main factors that led to the out performance of the Euro, Australian, New Zealand and Canadian dollars, against the US dollar last year.
As we enter 2008, we are beginning to see recoupling in the global economy. In second half of last year, the expansion in the UK and Canada began to slow materially as economic data weakened, indicating that these countries were no longer resilient to weaker US growth. The ripple effects of the US subprime crisis has impacted many countries, especially the UK, who has relied on housing, finance and the public sector for growth over the past few years. Chinks in the armor are also beginning to show in the Eurozone despite the central bank’s persistently hawkish monetary policy stance. If growth slows even further in the US or the other countries, the central banks that have been reluctant to ease rates last year may be forced to do so. The UK for example has already cut rates and they are expected to again in 2008. These are where the surprise elements lie for the currency market because the Federal Reserve has already cut interest rates by 100bp this past year. Another rate cut from them will not be much of a surprise, but if the Eurozone begins to cut interest rates as well, it would mark a significant shift in monetary policy, which in turn could result in a major shift to the outlook for the currency.
US: Recession or No Recession?
Global growth in 2008 is also dependent upon whether the US economy falls into a recession, which will be the big debate of 2008. Over half of the American public believes that we are already in a recession according to a CNN/Opinion Research Corporation poll released in December. This view is shared by Pimco’s Bill Gross who thinks that we fell into a recession in December and that it should last for the next four to five months. Economists however beg to differ. Out of 54 economists surveyed by Business Week in December, only 2 expect the US economy to fall into a recession. As a group, they believe that on average, the US economy will grow by 2.1 percent from the fourth quarter of 2007 to the end of 2008 versus 2.6 percent growth in 2007. This does not mean that times may not be difficult in 2008, especially in the first half of the year because even though consumer spending is not stopping, it is certainly slowing. The labor market has held steady, while average hourly earnings have increased. Even though energy prices are high, the threat of $100 oil is easing. The forecast that the US economy will not fall into a recession is predicated on the belief that the Federal Reserve will continue to lower interest rates. We still expect more losses in the subprime sector and the Federal Reserve’s commitment to easing will be needed to help restore confidence. Realistically, no one expects the problems in the credit market to just disappear, but if the Fed is on the case, then the US economy has a good chance of recovering next year.
How Much More Easing Can We Expect from the Federal Reserve?
The only question is how much more easing can we expect from the Federal Reserve. Each rate cut that the Fed has given to the markets in 2007 has been a reluctant one. It seems that they only deliver exactly what has been priced in and nothing more. There is a good reason for that of course, which is inflation. Like the central banks in the rest of the world, the Fed has to make sure that inflation does not get out of hand. The double whammy of high energy prices and a weaker dollar has made the problem an even bigger issue for the US central bank. We expect another 25 to 50bp of easing, but interest rates are not the Fed’s only option. Unless oil prices drop back down to $50 a barrel, they will need to be more creative. The Term Auction Facility introduced by the Federal Reserve last month is one of those methods. The primary problem lies in LIBOR rates which have remained stubbornly high; there were days in December where Treasuries recorded their biggest one day rally in 3 years. Central banks have also extended their loans for Wall Street dealers to attempt to improve credit conditions. Lowering the discount rate is also possible, but with the Fed fund’s rate specifically, their options could be limited.
Don’t Underestimate Sovereign Wealth Funds
Sovereign wealth funds are also coming to the rescue. Banks across Wall Street have reported major losses this year and the only thing that has stopped the stock market from collapsing are the bailouts from sovereign wealth funds. Although these funds have existed since the 1950s, their total size has increased dramatically in the past decade. In 1990, the total size of the funds where estimated to be $500 billion, but today, it is estimated to be $3 trillion. Just between the U.A.E, Singapore, Norway, Saudi Arabia, Kuwait and China, there is as much as $2 trillion to spend – and they are already spending it. Just in the last two months of 2007, Singapore’s state owned Temasek holdings announced a $4.4 billion investment in Merrill Lynch, the Abu Dhabi Investment Authority bought a $7.5 billion stake in Citigroup while the China Investment Corp made a $5 billion investment into Morgan Stanley. The capital of these funds is expected to grow to as much as $12 trillion over the next eight years. Where does this money come from? Foreign Exchange reserves and natural resources. The investments by the government sponsored funds have played a major role in helping the US dollar recover in the fourth quarter and even though these trends could receive backlash from Congress, we expect it to continue.
How Could the 2008 Presidential Elections Impact the Financial Markets
2008 is also an Election Year. Historically, a Republican leadership has been more bullish for the dollar than a Democratic leadership. This will of course depend upon how close the elections will be in 2008. The general belief is that Republicans are more business friendly while Democrats are more apt to raise taxes. According to the Stock Traders Almanac, election years are also modestly positive for US stocks. Since the 1950, the S&P500 has only had one loss in the last seven months of an election year. Also, “In the last 50 years, election years have ended lower twice in 11 occurrences with an average Dow gain of 9.2%. Over the same 50 years, 15 bear markets have occurred. Four (1960, 1968, 1976 and 2000) have commenced in an election year. Just three (1960, 1980 and 1984) have ended in election years.”
The Impact of a Strong Euro Surprises Everyone
Meanwhile the fate of the EURUSD is also dependent on the outlook for the Eurozone. In a year where the ECB raised interest rates by 50bp while the Federal Reserve cut interest rates by 100bp, there is no wonder why the EURUSD rose to an all time high of 1.4968. Throughout the past year, the fear and belief in the markets was that the strong Euro would take a major toll on the region’s economy, but it did not. Instead, growth remained strong as Germany’s trade surplus climbed to a record high in month of October thanks to an unexpected rise in exports. Even though exports to the US dropped, demand from within the Eurozone and emerging markets like China helped to fuel growth. Having learned the lessons of being under hedged when the EURUSD hit a high of 1.36 in 2004, many Eurozone corporations have done a much better job of hedging foreign exchange risk in 2007. In order to mitigate the impact of a weakening dollar, many corporations have also taken measures to produce more locally. Although there are still companies that have been affected by the strength of the Euro like Airbus who called the currency’s appreciation “life threatening,” growth in the overall region was much than the market expected last year.
Eurozone Growth Beginning to Slow
However as we enter 2008, Eurozone growth is beginning to slow. German business confidence fell to a 2 year low amidst concerns that higher borrowing costs, tight credit markets and rising inflation could take a toll on the economy. In fact, the European Commission and the European Central Bank both believe that growth will be slower than their initial forecasts. The ECB no longer argues that the Eurozone can remain completely immune to the US business cycle. Their recent liquidity injections are proof that this is no longer the case. In fact, the last Eurozone consumer spending, manufacturing and service sector PMI numbers released in 2007 all reported deterioration from the prior month. If the ECB continues to refuse to lower interest rates, then we could see a serious slowdown in 2008.
Is an ECB Rate Hike Really Possible?
Up until the very end of 2007, ECB President Trichet reminded the markets that the central bank is hawkish and will do all that it takes to make sure there is no second round inflation effects. He also clarified that their desire to contain inflation will not be distracted by the interest rate cuts from the UK and the US. As a central bank that focuses heavily on price stability, the fact that inflation has breached their 2 percent target in the second half of the year raised red flags. Since then, they have done nothing but threaten the markets with higher interest rates. Yet, the last time the ECB raised rates was in June, leading many people to wonder whether they are all talk and no action. In fact, even though they haven’t touched interest rates, their massive liquidity injections suggest that at the moment their actions favor looser monetary policy. In early December, 3 month Euro LIBOR rates hit 6 year highs while sterling 1 month LIBOR rates hit 9 year highs. When the rates refused to come down, the ECB was forced to add $500 billion into the banking system. For the time being, this seems to have worked but it still remains questionable as to how long low LIBOR rates will last. Therefore even though a rate hike is possible, it is not probable. In fact, we could see a rate cut from the ECB before a rate hike, but this will be dependent upon inflation. If we see $100 oil again, then the central bank will not hesitate to raise rates, just as they have warned throughout 2007. If inflation remains at current levels or begins to cool, then a rate cut before a rate hike is more likely.
Interest rates are the primary driver of currency market fluctuations and that will remain the case in 2008. The recovery of the US economy and the US dollar in the second half of the year will be contingent upon further easing by the Federal Reserve and easing by the European Central Bank. However even if the ECB is unable to ease rates, if they shift their monetary policy from hawkish to neutral or dovish, that may be enough to trigger a recovery in the US dollar in the second half of the year. Recoupling is not something that happens overnight, we expect this trend to begin manifesting itself in the second or third quarter of 2008. In the meantime, it may be interesting to some traders that the dollar tends to strengthen in the month of January according to our Seasonality Study. The major shift in the markets that everyone has been hoping for will happen when we stop hearing bad news and start hearing some good news - banks need to take all of their off balance sheet losses now and stop delaying them if they want the global economy to recover.
EURUSD Technical Outlook: A Major Burst before a Turn – By Jamie Saettele
Last quarter, we called for a rally to 1.4580 and then a top and reversal. As the pattern has evolved, so has our outlook. In the technicals, we focused recently on 1.4309 as a potential terminus for wave iv (within the 5 wave rally from 1.3261) of larger 3 (within the 5 wave rally from 1.2865). Wave v of 3 should exceed 1.4967 over the next month or so. An objective is at 1.5364, which is the 61.8% extension of i through iii. COT data supports an aggressive bullish bias over the next few weeks (at least) as both Euro bearish sentiment extremes and USD bullish sentiment extremes have recently been registered. This rally could extend towards 1.6000. Currencies have a tendency to sport 5th wave extensions which is consistent with a blow-off top, which happens so often in the currency and commodity markets (currency really is a commodity anyway). As always, the form of the pattern is the most important aspect when determining when a rally or decline is coming to an end so keep abreast of the current pattern (as well as high probability entry and exit points) by checking the daily technicals.