Future Moves of Euro-Dollar

EUR/USD has been establishing fresh highs almost daily for the past two weeks.  The upward movement in the currency pair is due to a variety of factors pointing to both euro strength and dollar weakness.   Economic growth within the Eurozone is forecast to be 2.6% in 2007, putting the 13-country region at a pace behind only Great Britain among the industrialized world.  Also, most currency analysts expect at least one more rate hike this year, probably in October.  Money follows yield in the forex market, and that is certainly true with the euro.  And when analyzing this currency pair, it is impossible to ignore the recent comments of ECB members Stark and Papademos when they talk about the strength of the economy and the threat of inflation.

The weak dollar is also to blame for a lot of the support underneath EUR/USD.  Subprime mortgage losses and concerns in the credit market overall have scared off a lot of dollar investors.  Countrywide Financial Corp., the country’s largest mortgage lender, reported its third straight quarterly decline in profit and lowered its forecast for next year.  The price of credit has surged as traders continue to be worried about the possibility of the subprime crisis spilling over into other parts of the economy.  If the issues spread into the larger credit market, we will see a significant knock on growth, and it is this problem that has led to the significant dollar selling in the forex market.  Yesterday, we talked about how the weak dollar made US assets cheap and attractive.  But if the dollar continues to slide, then the assets being held drop in value.  Just the perception of dollar weakness can ignite a massive sell-off in dollar-denominated assets.

It is not certain, however, that we will see the bottom fall out in the US dollar.  Today’s currency trading has provided mixed signals for the future.  French consumer spending was a positive, coming in at 1.6% vs. 0.7% expected.  Italian Retail Sales was a slight disappointment, however, rising only 0.1% vs. 0.3% expected.  Even worse, the manufacturing PMI reading fell to 54.8.  Not only is that lower than the 55.5 forecast, but it is the first time the reading fell below the 55.0 level since February 2006.  The Eurozone economy is much more dependent on manufacturing and exports than either the United States or Great Britain, and this may be the first sign that the high exchange rate is dampening European growth.  The mixed bag of data threw currency traders for a loop and kept the euro trading around 1.3800.

So what can we expect from the forex markets in the future?  New French President Sarkozy is still clamoring for more political say in the decisions of the European Central Bank.  What that means for us is that he wants a larger emphasis placed on stimulating growth as opposed to containing inflation (low interest rates).  ECB President Trichet should be able to resist this intrusion, and the monetary policy makers are likely to raise rates to 4.25% by October of this year.  That is fundamentally positive for the euro, especially since the US Fed is likely to keep rates constant for the rest of 2007.  But technical analysis of the forex market does paint a different picture, as most signs point to the euro being overbought and the US dollar being oversold.  As such, instead of seeing the EUR/USD march toward 1.4000, we should instead see a correction and a rise in the value of the dollar.