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From FXCM
Euro At All Time Highs - How Much Further Can It Go?
Published: 12/17/03
A few months ago we published a piece titled EURO - Where Can It Go? 1.30 or 1.05? With the EURUSD making new all time highs on the 1.24-handle, we are revisiting this topic, but now asking ourselves, how much further can the euro rally? With the lack of a clear catalyst to reverse the dollar's decline, the EURUSD appears poised to move towards 1.28/1.30 in the next few months.
What will cause the EURUSD trend to continue?
The continuation of the EURUSD trend is contingent upon the continuation of current US and European fundamentals. We have repeatedly explained the rationale for the decline in the dollar, but will recap them briefly:
1) Large and growing current account deficit
2) Lack of foreign investment to fund the deficit
3) Low interest rates / unattractive yields
4) Eurozone economic recovery
Current Account Deficit Reversal Requires Further Dollar Depreciation
In 2003, we have learned that the US dollar has decoupled from improving US economic data and equity market performance. Improving economic data has become essentially immaterial to the market as we come to realize that if 8.2% Q3 GDP growth cannot push the dollar higher, then we doubt that any other economic release expected in the near future will have the potency to do so. Instead, the market turned its focus to the magnitude of the current account deficit, which is currently hovering around 5% of GDP. Studies show that current account deficits greater than 5% of GDP leave an economy vulnerable to sharp currency depreciations. Based upon a study by Caroline Freund (Fed economist) of industrialized nations between 1980-1997, current account deficit reversals generally begin when the current account deficit is approximately 5% of GDP. The reversal tends to take 3-4 years and involves slowing income growth and a significant trade weighted exchange rate depreciation. The overall average exchange rate depreciation is on average 20%, with the decline beginning 1 year before the current account deficit hit its trough and continuing for three years. The current account deficit for Q3 is 4.9% of GDP, which is a rebound from the record low of 5.2% in Q1. If we assume that we have already seen the trough this year, then over the past 12 months, the Fed's real broad trade-weighted dollar index has declined approximately 9% - implying that we should expect another 11% depreciation over the next 2 years.
Central Banks Are the Primary Source of Funds for the Deficit
Aside from the required continued depreciation of the dollar to reverse the deficit, the current source of funding for the deficit also poses a significant concern. Over a quarter of the deficit is currently being funded by foreign official institutions such as central banks. Asian central banks are estimated to own 70% of global currency reserves. The Fed's latest custody holdings data for the week ending December 10th shows that global central banks bought another USD$8bln in treasuries, bringing their total holdings to USD1.04trln. This puts the four-week sum at $42.65bln (the October trade deficit was $41.8bln). Clearly, central banks have been funding a large part of the deficit and not private investment. Therefore should these central banks reduce the aggressiveness of their US fixed income asset accumulation, this could result in a combination of higher bond yields, which would hurt the recovery AND a weaker dollar.
US Fundamentals - Falling CPI May Prevent Fed From Hiking Rates in Q1
One of the primary factors deterring private foreign investment is the low yield offered by the United States. As long as interest rates remain low and the Fed maintains an accommodative monetary policy stance, the US will face fierce competition for foreign investment with countries such as Australia, New Zealand, and the UK. November's CPI release validates the Fed's assessment of inflation, which is that "increases in core consumer prices are muted and expected to remain low." Consumer prices excluding the volatile food and energy components fell for the first time in 21 years. This clearly confirms that inflation is still very low, as prices of airfares, clothing and lodging continue to trend lower. As long as this is the case, the Fed may opt to maintain an accommodative monetary policy for a longer period of time.
What could reverse the EURUSD trend?
Fed or ECB Intervention
Intervention by the Federal Reserve or the European Central Bank (ECB) to sell euros and buy dollars would have a very significant impact on the value of the EURUSD. Although the market discounts the effectiveness of intervention by the Bank of Japan and uses their intervention as an opportunity to sell at better levels, intervention by the Federal Reserve and the European Central Bank (ECB) is different because both central banks rarely choose intervention as an option. The last time the Fed and the ECB intervened was in November of 2000 when they bought euros and sold dollars below the 0.90 level.
However, we doubt that the Fed or the ECB has any intentions of intervening in the near future. The Fed seems quite comfortable with the current level of the dollar, while ECB Chief Economist Issing feels that the euro is simply trading in line with its long-term average. Furthermore, a recent article by Market News reports that conversations with ECB sources revealed that, "they did not expect the ECB would consider intervening unless the euro-dollar rate rose to around $1.35, near the all-time highs of the "synthetic" euro prior to 1999." Although ECB officials will certainly become increasingly uncomfortable with the Euro as it continues to appreciate, verbal intervention will surely precede actual intervention. However, we have yet to hear verbal intervention from any members of the ECB.
Early Rate Hike
Gold Prices Forecast Rise in Inflation - If the Fed shocks the market with an early rate hike, we could see a sharp reversal in the US dollar. The rate hike needs to be coupled with an optimistic outlook for the US economy and a hint that more hikes will be coming in the months ahead to have a truly significant impact on the dollar. The possibility of an unexpected rate hike is not completely implausible. Gold prices are closely watched by the Federal Reserve - the recent sharp gains in gold prices are signaling that the Fed may need to raise rates soon. Gold is currently trading above $400/oz, and if history can be a reliable indicator, the Federal Reserve typically maintains a tightening bias when gold rises above $400/oz. This logic makes intuitive sense, as gold is also an inflation hedge. When gold prices rise above $400/oz, the market is signaling to the Fed that they that believe that monetary policy has become too accommodative. However, as mentioned earlier, the latest CPI data indicates that inflation has yet to become a concern, but we do want to note that according to a report by the Federal Reserve, the CPI inflation rate does tend to lag gold by a year. Gold prices are important since it accounts for up to 70% of the variation in the inflation rate.
Economy Has Been Expanding - Growth Secured - With 8.2% Q3 GDP growth, which is the fastest pace in 20 years, there is no question that the US economy is recovering. Optimism has swept the markets as both businesses and consumers adjust to the notion that 2004 will be better than 2003. Business sentiment surveys confirm this optimism. Productivity also incurred its biggest gains since 1983 while business investment rose 14% in November. A surge in profits has increased corporate spending and hiring - non-farm payrolls rose three consecutive periods thus far. Strong gains are expected in consumer spending during this month's holiday season. However, although improving economic fundamentals may prompt the Federal Reserve to move monetary policy earlier than expected, this argument is weak given the low rate of inflation and the excess slack in labor and capital resources.
Stronger arguments for continued Euro strength
Despite the risk of a reversal in the EURUSD, the arguments for continued Euro strength definitely outweigh the arguments for a reversal. The weakness of the dollar is structural and unless there is a significant shift in foreign sentiment towards US assets, the weakness of the dollar is expected to persist into 2004.
Euro At All Time Highs - How Much Further Can It Go?
Published: 12/17/03
A few months ago we published a piece titled EURO - Where Can It Go? 1.30 or 1.05? With the EURUSD making new all time highs on the 1.24-handle, we are revisiting this topic, but now asking ourselves, how much further can the euro rally? With the lack of a clear catalyst to reverse the dollar's decline, the EURUSD appears poised to move towards 1.28/1.30 in the next few months.
What will cause the EURUSD trend to continue?
The continuation of the EURUSD trend is contingent upon the continuation of current US and European fundamentals. We have repeatedly explained the rationale for the decline in the dollar, but will recap them briefly:
1) Large and growing current account deficit
2) Lack of foreign investment to fund the deficit
3) Low interest rates / unattractive yields
4) Eurozone economic recovery
Current Account Deficit Reversal Requires Further Dollar Depreciation
In 2003, we have learned that the US dollar has decoupled from improving US economic data and equity market performance. Improving economic data has become essentially immaterial to the market as we come to realize that if 8.2% Q3 GDP growth cannot push the dollar higher, then we doubt that any other economic release expected in the near future will have the potency to do so. Instead, the market turned its focus to the magnitude of the current account deficit, which is currently hovering around 5% of GDP. Studies show that current account deficits greater than 5% of GDP leave an economy vulnerable to sharp currency depreciations. Based upon a study by Caroline Freund (Fed economist) of industrialized nations between 1980-1997, current account deficit reversals generally begin when the current account deficit is approximately 5% of GDP. The reversal tends to take 3-4 years and involves slowing income growth and a significant trade weighted exchange rate depreciation. The overall average exchange rate depreciation is on average 20%, with the decline beginning 1 year before the current account deficit hit its trough and continuing for three years. The current account deficit for Q3 is 4.9% of GDP, which is a rebound from the record low of 5.2% in Q1. If we assume that we have already seen the trough this year, then over the past 12 months, the Fed's real broad trade-weighted dollar index has declined approximately 9% - implying that we should expect another 11% depreciation over the next 2 years.
Central Banks Are the Primary Source of Funds for the Deficit
Aside from the required continued depreciation of the dollar to reverse the deficit, the current source of funding for the deficit also poses a significant concern. Over a quarter of the deficit is currently being funded by foreign official institutions such as central banks. Asian central banks are estimated to own 70% of global currency reserves. The Fed's latest custody holdings data for the week ending December 10th shows that global central banks bought another USD$8bln in treasuries, bringing their total holdings to USD1.04trln. This puts the four-week sum at $42.65bln (the October trade deficit was $41.8bln). Clearly, central banks have been funding a large part of the deficit and not private investment. Therefore should these central banks reduce the aggressiveness of their US fixed income asset accumulation, this could result in a combination of higher bond yields, which would hurt the recovery AND a weaker dollar.
US Fundamentals - Falling CPI May Prevent Fed From Hiking Rates in Q1
One of the primary factors deterring private foreign investment is the low yield offered by the United States. As long as interest rates remain low and the Fed maintains an accommodative monetary policy stance, the US will face fierce competition for foreign investment with countries such as Australia, New Zealand, and the UK. November's CPI release validates the Fed's assessment of inflation, which is that "increases in core consumer prices are muted and expected to remain low." Consumer prices excluding the volatile food and energy components fell for the first time in 21 years. This clearly confirms that inflation is still very low, as prices of airfares, clothing and lodging continue to trend lower. As long as this is the case, the Fed may opt to maintain an accommodative monetary policy for a longer period of time.
What could reverse the EURUSD trend?
Fed or ECB Intervention
Intervention by the Federal Reserve or the European Central Bank (ECB) to sell euros and buy dollars would have a very significant impact on the value of the EURUSD. Although the market discounts the effectiveness of intervention by the Bank of Japan and uses their intervention as an opportunity to sell at better levels, intervention by the Federal Reserve and the European Central Bank (ECB) is different because both central banks rarely choose intervention as an option. The last time the Fed and the ECB intervened was in November of 2000 when they bought euros and sold dollars below the 0.90 level.
However, we doubt that the Fed or the ECB has any intentions of intervening in the near future. The Fed seems quite comfortable with the current level of the dollar, while ECB Chief Economist Issing feels that the euro is simply trading in line with its long-term average. Furthermore, a recent article by Market News reports that conversations with ECB sources revealed that, "they did not expect the ECB would consider intervening unless the euro-dollar rate rose to around $1.35, near the all-time highs of the "synthetic" euro prior to 1999." Although ECB officials will certainly become increasingly uncomfortable with the Euro as it continues to appreciate, verbal intervention will surely precede actual intervention. However, we have yet to hear verbal intervention from any members of the ECB.
Early Rate Hike
Gold Prices Forecast Rise in Inflation - If the Fed shocks the market with an early rate hike, we could see a sharp reversal in the US dollar. The rate hike needs to be coupled with an optimistic outlook for the US economy and a hint that more hikes will be coming in the months ahead to have a truly significant impact on the dollar. The possibility of an unexpected rate hike is not completely implausible. Gold prices are closely watched by the Federal Reserve - the recent sharp gains in gold prices are signaling that the Fed may need to raise rates soon. Gold is currently trading above $400/oz, and if history can be a reliable indicator, the Federal Reserve typically maintains a tightening bias when gold rises above $400/oz. This logic makes intuitive sense, as gold is also an inflation hedge. When gold prices rise above $400/oz, the market is signaling to the Fed that they that believe that monetary policy has become too accommodative. However, as mentioned earlier, the latest CPI data indicates that inflation has yet to become a concern, but we do want to note that according to a report by the Federal Reserve, the CPI inflation rate does tend to lag gold by a year. Gold prices are important since it accounts for up to 70% of the variation in the inflation rate.
Economy Has Been Expanding - Growth Secured - With 8.2% Q3 GDP growth, which is the fastest pace in 20 years, there is no question that the US economy is recovering. Optimism has swept the markets as both businesses and consumers adjust to the notion that 2004 will be better than 2003. Business sentiment surveys confirm this optimism. Productivity also incurred its biggest gains since 1983 while business investment rose 14% in November. A surge in profits has increased corporate spending and hiring - non-farm payrolls rose three consecutive periods thus far. Strong gains are expected in consumer spending during this month's holiday season. However, although improving economic fundamentals may prompt the Federal Reserve to move monetary policy earlier than expected, this argument is weak given the low rate of inflation and the excess slack in labor and capital resources.
Stronger arguments for continued Euro strength
Despite the risk of a reversal in the EURUSD, the arguments for continued Euro strength definitely outweigh the arguments for a reversal. The weakness of the dollar is structural and unless there is a significant shift in foreign sentiment towards US assets, the weakness of the dollar is expected to persist into 2004.
...you don't want to start a war here on the forum 
