Euro Makes Small Comeback on U.S. Dollar

Despite last week’s small gains against the euro, the U.S. dollar fell against the European currency on speculation of further weak U.S. growth. It may seem like old news, but investors fear further losses on securities backed by subprime mortgages to weaken the U.S. economy. Today, Germany’s IKB Deutsche Industriebank AG reported losses directly linked to the U.S. subprime mortgage crisis. Along with last week’s Deutsche Bank report, this indicates corporate debt to be at risk from the weak housing market. The dollar fell to 1.3678 against the euro this morning, a 0.3 percent drop from last week.

The risk of owning corporate debt has sky-rocketed, also a factor in the euro gain. Bond buyers have been demanding higher risk premiums on corporate debt as risk-aversion has increased. According to index data by Merril Lynch, the spread that investors demand on corporate debt instead of holding U.S. Treasuries has widened 20 basis points this week to 128 basis points. Investors fear corporate debt will be taking hits from the subprime meltdown.

Currency Outlook and Strategy:
Tomorrow at 8:30 a.m. the U.S. Commerce department is due to release a report on U.S. consumer spending. Economists from a Bloomberg news survey speculate personal spending rose 0.1 percent in June, the least since September. Ever since U.S. personal spending has slowed from a 5-month high in December, the dollar has fallen 3.5 percent against the euro. Even though a weak spending forecast is already factored in the EUR/USD price, there is room for a further fall if the U.S. Federal Reserve decides to lower interest rates. Kenta Inoue, economist and currency analyst at Mitsubishi UFJ Securities in Tokyo, states: “I expect the U.S. economy to slow and the Fed to lower rates in the 4^th quarter. There is still room for rates to rise in Europe, so investors will start to favor European currencies over the dollar.”

And this brings up another question: Will the European Central Bank raise their federal funds rate above the current benchmark of 4.00 percent? There is much speculation the ECB will hold onto the current rate after its next meeting on August 4^th, but is likely to raise rates later in September. This increase may mean further appreciation in the euro, a main worry of French President Nicolas Sarkozy. But recent data has shown an appreciating euro has not hurt the euro-region as a whole. Exports from the EU rose 9 percent in 5 months through May from a year earlier, the second fastest pace in 6 years. This begs the question why an appreciating euro has not hurt exports. The reason is that against the currencies of the EU’s 25 trading partners, the euro has increased less than half as a much as against the U.S. dollar. Exports to the U.S. may have been hurting, but with Germany as the world’s largest exporter, exports to other countries have more than made up for losses.

Another benefit from a rising euro has been lowered costs of oil, which is priced in U.S. dollars. The price of oil has risen 26 percent this year to $76.73 a barrel today. Despite hurting some European corporations like Airbus and Peugeot (charts), the overall euro-region seems to be withstanding the euro impact. The ECB is forecasting economic growth at 2.6 percent for 2007.