One of the most dominant trends in the financial markets in the first half of 2008 has been relentless US dollar weakness. Not only did the movements in the greenback impact the values of many currencies around the world, but the dollar has also contributed significantly to the rally in oil prices and by extension, the turbulence in equity and bond markets. With the exception of the Canadian dollar, the greenback has sold off against every other G10 currency since the beginning of the year. The most significant weakness has been against the Swiss Franc, followed by the Australian dollar and then the Euro. However much of that decline occurred in the first three months of the year as the performance of the dollar has been mixed since April.
In the second quarter, both dollar bulls and bears managed to be profitable depending on the selection of their trades. The greenback was virtually unchanged against the Euro but rose 5 percent against the Japanese Yen and fell 5 percent against the Australian dollar. The divergent performance of the US dollar was largely dependent upon the hawkishness or dovishness of other central banks as the Federal Reserve brought their easing cycle to an end.
Oil is Determining Fed Policy
To the Federal Reserve’s dismay, oil is determining Fed policy. Since the beginning of the year, crude prices have increased from $93 a barrel to a high of $144 a barrel, which is a rise of approximately 50 percent. If it were not for oil, the Federal Reserve would probably continue to lower interest rates or at least keep them unchanged for the remainder of the yea .in the midst of what is clearly a deteriorating US economic background. Unfortunately Chairman Bernanke and the rest of the FOMC does not have the luxury of concentrating their efforts on growth like Greenspan’s Fed did after the technology bubble burst in 2001. Oil has become a double edged sword by threatening both inflation and consumer spending. Consumer prices grew by 4.2 percent on an annualized basis in the month of May and could very well top 5 percent in the third quarter. Although the Fed is supposed to focus on core prices, which have been more muted, they have becomes alarmed about the rise of inflation expectations which have been driven almost exclusively by energy prices. This has forced vendors across the nation to either raise prices or add fuel surcharges. Once prices are increased, it will be very difficult to convince vendors to reduce them unless they are assured that oil and food prices will spike again.
Federal Reserve: A Third Quarter Rate Hike?
The Federal Reserve delivered their last interest rate hike of this cycle on April 30th. At the June meeting, which also happened to be their last meeting in the second quarter, the central bank left interest rates unchanged at 2 percent. This was the first time that they have paused since cutting rates by 325bp in the last 8 months to fend off slowing growth. Unfortunately growth has not picked up, but changes to interest rates tend to have a lagging effect on the US economy which is part of the reason why the Fed has stopped easing. The other reason is the sheer fact that they have no choice. Since the third quarter of last year, the Fed has focused almost exclusively on growth. Now that inflation and inflation expectations have gone through the roof, they need to start looking for ways to reduce inflationary pressures if they want to avoid an oil price shock similar to the 1970s. As a result, the market is currently expecting a rate hike in the third or fourth quarter. Fed fund futures are pricing in a 65 percent chance of a quarter point rate hike at the September meeting and an 81 percent chance of a rate hike at the October meeting. Before the June Fed meeting, the futures contracts were pricing in a 99.9 percent chance of a September hike at one point. That expectation has of course been pared significantly since the last Fed meeting and will change based upon incoming economic data.
The upcoming US Presidential elections will also not hold the central bank back from raising interest rates. Over the past 4 decades, there have been 10 elections not including the upcoming one. In 7 out of the past 10 elections, rates were increased at one point or another during the election year. For example in 2004, when George W Bush was up for reelection, interest rates were 1% in January 2004 and 2.25% in December. In 1988 during Reagan’s first election, interest rates were tightened from 14% to 20%. Elections should not factor into the Federal Reserve’s monetary policy decisions but the FOMC may choose to by September so as to not appear as impartial as possible just before the November election.
When Will the US Consumer Buckle?
One of the main reasons why the Federal Reserve may actually feel comfortable raising interest rates is the surprising strength of consumer spending. Even as gas prices have topped $4 a gallon and is now inching towards $5 a gallon, consumer spending is relatively steady. Retail sales have actually increased in March, April and May. Food and energy prices can be blamed for part of the rise, but spending on clothing, sporting goods, health and personal care have also increased consistently between March and April. Therefore although consumer confidence has plunged to record lows, consumer spending has not followed suit. Since the beginning of the year, retail sales were negative only in the month of February. It may however just be a matter of time before spending slows. We’ve already seen widespread reports in the Wall Street Journal and the Financial Times about the difficulties US consumers are facing across the nation and eventually those difficulties will be reflected in the retail sales data.
Labor Market: String of Job Losses Set to Continue
As for the labor market, expect job losses to continue. June marked the sixth consecutive month of negative job growth. Most people including Warren Buffett already believe that the US economy is in a recession and during recessions, job losses build quickly. Over the past 3 decades, the US economy has gone through 3 recessions and in each of those 3 recessions, there was a string of job losses that lasted for a minimum of 10 months. Many people argue that the current downturn in growth could be more severe than the recession in the early 2000s due to the triple blow of a housing crisis, credit crunch and skyrocketing commodity prices. If this is true, we will see far more than 4 consecutive months of job losses. In each of the past 3 recessions, the largest single month job loss was more than 300k. In this context, a further deterioration in the labor market is not only realistic but almost assured. Companies such as Citigroup and Goldman Sachs have already announced additional layoffs and problems in the UWS auto sector may trigger much larger employee firings in the near future.
The US Dollar At or Near a Bottom
Despite the latest weakness in the US dollar, the greenback is already at or very near a bottom. The Federal Reserve has cut interest rates by 325bp since last August and even if they are slow to raise rates, they have run out of room to cut them further. Other central banks on other hand have been far more conservative with rate cuts or they haven’t cut interest rates at all which means that they on the other hand do not have much room to raise them. As global growth continues on a downward spiral, central banks that are looking to raise rates to anchor inflation expectations (such as the ECB) create serious risks for their economic growth going forward. If the ECB proves to be a one hit wonder by raising interest rates only once this year and the Fed ends up being more aggressive, then a bottom would be cemented in the US dollar.
Official comments from the G8 would also help the US dollar tremendously. Over the past few decades, G7 or G8 meetings have triggered major turns in the US dollar. With the weakness of the greenback driving energy prices higher, the other members of the G8 may press for a stronger dollar. Recent comments from various members of the Bush Administration indicate that they also want to pay more than just lip service to the strong dollar policy. China has been unusually vocal about their desire to see the dollar stabilize. If the G8 alters the FX language in their communiqué to collectively call for a stronger dollar, then that is exactly what we will see.
Euro Bye Bye Boom
As for the Euro, despite record high exchange rates, materially higher interest rates and soaring energy prices the first half of 2008 has been a surprisingly strong period of economic growth for the 15 member European Union. Eurozone GDP expanded at annual rate of 2.2% versus the anemic 1% pace for US. The boom in EZ has been led by the export sector, most notably in Germany as gains in efficiency coupled with strong demand from emerging markets of China, Russia and Middle East have helped producers in metal, electronics and car industries create more jobs at the start of the year than at any time in the past four decades.
However as we turn to the second half of 2008 the party may be coming to an end. The trifecta of high exchange rates, high interest rates and record high petrol prices is clearly starting to weigh on European economy. The latest readings from both consumers and producers suggest that a material slowdown is likely to occur as we head into Q3 of 2008. On the consumer front the GFK confidence survey in Germany, the region’s largest and most important economy has dropped from 5.3 to 3.9 in just two months. The 3.9 reading was the lowest value since the survey began suggesting that despite the seemingly steady economic growth, consumer attitudes are decidedly bleak. Consumer surveys from France, Italy and the other major economies of the EZ confirm this dour trend. Producer gauges for their part are also showing signs of serious deterioration. The latest flash Manufacturing PMI data printed at 49.1 - below the critical 50 boom/bust line registering its worst reading in more than 3 years. Furthermore, the IFO survey also surprised to the downside printing at 101.3 versus 103.5 projected its weakest result in more than 2 ½ years. In short the EZ economy may be facing far greater challenges in the second half of the year than the first as consumers grapple with alarmingly high prices while producers are forced to adjust to weaker global demand.
ECB Full Speed Ahead
However, despite clear signs of an economic slowdown the ECB has not changed its resolutely hawkish stance. If anything EZ monetary policy has become even more restrictive as high energy and food costs have sent headline inflation in the region soaring well above ECB 2% target. In fact inflation in the EZ increased to 3.7% - its highest reading this decade prompting ECB chief Jean Claude Trichet to issue a stern warning to the market. President Trichet took the market completely by surprise when he casually mentioned at the post announcement news conference on June 5th that “It's not excluded that, after having carefully examined the situation that we could decide to move our rates for a small amount at our next meeting.'' On July 3, Trichet made good on his word and the ECB hiked rates to 4.25%
This turn towards hawkishness has been the single biggest reason for euro’s recent appreciation. With interest rate differential in the EURUSD now at 225bp, the speculative flow has been moving to the euro ever since Mr. Trichet’s words hit traders’ computer screens. The only question left regarding ECB monetary policy going forward is “one and done” or is there more to come? Mr. Trichet himself has been careful to stress that ECB objective is not to initiate a series of hikes. Rather, the central bank simply wants to anchor inflation expectations in the face of what it perceives as relentless price pressures that could turn into a runaway problem for monetary authorities in Frankfurt. Unlike the Fed, which is mandated with both controlling inflation and stimulating growth, the ECB focuses primarily on managing price pressures. In fact in his question and answer session in June Mr. Trichet clearly stated that it was the responsibility of fiscal authorities to manage growth. Therefore, another 25bp hike to take the ECB rates to 4.5% by year end would not be out of the realm of possibility, especially if oil prices continue their climb pushing headline rates higher. However, for now the ECB has remained resolutely non-committal and the lack of follow through from ECB has taken the wind out of the EURUSD rally.
Oil has become a critical variable in the currency market becoming positively correlated with the price of EUR/USD. While correlation does not mean causation, there are good fundamental reasons for why euro continues to march in lock step with crude. As oil prices rise creating upward pressure on prices throughout the economic chain, headline inflation in the EZ tends to follow suit. As inflationary gauges increase, the ECB becomes more and more likely to tighten rates further, thus spurring yet more speculative capital to flow into long euro positions. Therefore in the next quarter, the price of oil may be the single best determinant of EURUSD direction. If prices drop below the present $130/bbl level easing inflationary pressures across the board, the ECB is likely to ease its monetary policy as well putting downward pressure on the unit. On the other hand if oil prices remain sticky or worse continue to move inexorably towards the $150/bbl level the probability of further rate hikes from the ECB will rise markedly and the unit is likely to benefit from more speculative flows.
Risk of Recession Ahead?
Mr. Trichet’s nonchalance towards slowing economic conditions notwithstanding, the ECB faces the risk of being too restrictive for too long which in turn could increase the risk of tipping the whole region into a recession. While few analysts predict such a dire scenario for 2008, the economic conditions could deteriorate rapidly and force a much more accommodative posture from the ECB even if price pressures continue to mount. In our last quarterly report we noted that, “One of the key reasons for ECB’s staunch hawkishness has been the relatively buoyant labor picture. German unemployment continued to decline each month during the quarter while French unemployment reached a 20 year low. We have long contended that the ECB will not change its hawkish posture until and unless demand for labor in the region begins to contract.”
Contraction in the EZ labor markets may have already started. Last month German unemployment increased for the first time in almost 2 ½ years. Granted the uptick was modest, but it broke a trend of 29 consecutive months of job gains. If German unemployment once again begins to rise - and given the rising cost of capital and slowing global demand, there are good reasons to thinks so – the ECB may not have the freedom to raise rates further irrespective of the price pressures present in the system.
Over the past year EZ producers (more specifically Germany) have been extraordinarily successful at generating growth from the new emerging nation economies of China, Russia and Middle East. While both Russia and the GCC countries continue to be flush with cash from oil revenues and should remain solid markets for the region, China may see a sharp reduction in its capital spending plans after the Beijing summer Olympics. This is in turn could hurt the European capital goods sector which has been one of the primary drivers of growth in the region. Thus a toxic combination of higher rates, rising unemployment and slowing global demand could create a nasty downside surprise to EZ growth in the second half of 2008 making euro vulnerable to greater than expected economic weakness.
North – South Decoupling Continues
The stresses in the EZ economy can already be seen in the growing fissure between the region’s northern and southern economies. While Germany and Netherlands continue to perform relatively well, southern economies such as Italy, Spain and Greece face a far more problematic future. In Italy GDP growth has been practically stagnant with year over growth at a paltry 0.3%. In Spain budget deficits of more than 10% of GDP along with an imploding housing market suggest both structural and growth problems ahead. Finally Greece which generates 15% of its GDP from tourism may suffer this summer as record high euro prices make vacationing there unaffordable for most Americans.
Little wonder then that southern European officials have already started to complain about ECB’s uncompromisingly hawkish monetary policy. The conflict between the decidedly Bundesbanke attitude of the ECB versus the needs of southern block economies for a more accommodative approach may become political as summer turns to fall. Despite its success, the euro remains a currency without a country and should the policy differences in the region devolve into a serious political conflict, the impact on the units is likely to be negative.
EURUSD to Remain Contained Within its Range
Although the European economy has been able to weather high exchange rates, high interest rates and relentlessly high energy prices in the first half of 2008, the prospects for the rest of the year look considerably bleak. After hitting an all time high above 1.600 in April of 2008, the pair has basically range 1.50 to 1.60 and consolidating its gains. Euro’ s most recent strength has not been a function of economic growth, but rather surprisingly hawkish monetary policy from the ECB. However it remains to be seen how much further Mr. Trichet and company could ratchet rates higher given increasingly clear evidence of slow down in the region. ECB risks tipping the EZ economy into a recession and could exacerbate the simmering political tensions between the northern and southern nation states the longer it maintains its hawkish posture. In that respect oil prices will continue to be one of the most important variables for the FX market to monitor due to their impact on headline inflation. For the time being the pair appears to be contained by its 1.60 record high and should price pressures ease, the EURUSD could trade lower as ECB’s monetary policy will become more accommodative.
By Jamie Saettele
In Elliott, ‘it’s all about 5’s and 3’s’. What does this mean? 5 waves move with the trend and 3 waves move against the trend. The decline from 1.6018 to 1.5283, while sharp, was only in 3 waves (see inset). As mentioned, 3 wave movements are countertrend. Not only is there no evidence of a reversal, but the evidence suggests that the EURUSD is headed higher. Moreover, the EURUSD has held a trendline since August 2007 and recent COT positioning is suggestive of a EURUSD bottom. Bigger picture, our preferred count treats the drop from 1.6018 as wave IV (within the 5 wave advance from 1.1640). Wave V is considered underway as long as price is above 1.5303. Measured targets are at 1.6394 and 1.7077 (1.6394 is the 61.8% extension of .8227-1.3666/1.1640 in log scale and 1.7077 is the 100% extension of the same move in arithmetic scale). Under the alternate count, wave IV is still underway and could end as a triangle or a flat. If a triangle, then price remains above 1.5283 anyway. If a flat, then price would fall slightly below 1.5283 before price turns higher in wave V.