Category — Fundamental

Euro zone growth has exceeded the US contributing to the appreciation of the euro but after a closer look the EZ doesn’t look that healthy. Essentially Germany has pulled the Euro Zone forward for the past year while the PIGS otherwise known as Portugal, Italy, Greece, and Spain have stagnated or gone in recession. So to answer my own question, I seriously doubt the Euro will break 1.60 if Germany stagnates. The German current account was reported on Monday and it was slightly lower than expected at 14.5 billion instead of 14.7 billion expected. It is a small gap but the number that should alarm traders is the fact that the current account dropped by 3 billion from the previous month.

Does this point to a trend? Are high exchange rates hurting Germanys export lead growth? Perhaps and this will weigh on the ECB come June when they make their rate decision. The engine to European growth may be running out of gas, and the PIGS are not going to rescue Europe in the future sp we can look for a lot of range trading between 1.50 and 1.60.

The People’s Bank of China may be in a position to use its $1.33 trillion currency reserves as a bargaining tool against U.S. lawmaker demands. Xia Bin, director of financial research at the State Council Development Center, believes China can use its holdings of U.S. government debt to its advantage. As the world’s second-largest holder of U.S. Treasuries of $407 billion, the selling of U.S. asset holdings would significantly lower their value. U.S. Treasuries fell yesterday after traders cited in a U.K. Daily Telegraph report that China may threaten to sell its holdings in U.S government debt if the U.S. imposed trade sanctions (see more in an article by Kathy Lien).

On July 26^th, the U.S. Senate Finance Committee approved legislation that would place higher duties on Chinese imports. These higher duties should compensate for the undervalued yuan. U.S. lawmakers since the beginning of the year have expressed concerns that an undervalued yuan is hurting U.S. companies. The People’s Bank of China has bought huge sums of U.S. government debt in order to keep its yuan artificially low.

With a high foreign currency reserve, a central bank is able to issue more than sufficient amounts of its domestic currency to stifle demand. If demand decreases when the economy bottoms out, the central bank would have plenty of foreign reserves to buy back the domestic currency. The enormous influx of capital from its incredible trade surplus is what has allowed China to maintain the world’s largest foreign currency reserve.

Despite numbers for April and May this year showing cuts in PCB U.S. Treasury holdings after 17-months of purchases, the central bank has indicated it would cut holdings anytime soon. President Bush and Henry Paulson agree it would be “foolhardy” for China to cut holdings in U.S. debt. Selling off these assets would strengthen the yuan significantly and thereby lower export value. Both have indicated that a mutual trade flow without penalties on imports should persist. Yet, with its true actions always a secret to the public, it remains to be seen what the PCB will decide if U.S. import duties do come into play. The PCB could use its huge foreign reserves to put a dent into the U.S. economy. The situation has turned from a question of economic policy into a potential political showdown.  

After modest gains this week, the U.S. dollar fell against the yen and euro on news of poor U.S. jobs growth. A government report today showed 92,000 jobs added for July, falling well below expectations as 126,000 jobs were added in June. Economists at Bloomberg predicted 127,000 new jobs for the past month. In addition, the unemployment rate rose unexpectedly to 4.6 percent up from 4.5. These are signs the U.S. economy is still hurting from the subprime crisis as investors are losing this week’s earlier appetite for risk. The dollar fell to $1.3727 against the euro this morning in New York, down from $1.3703 yesterday. The increase in risk aversion has also caused the dollar to fall against the yen from 119.21 yesterday to 118.93 this morning.

Poor U.S. job growth and resulting increase in unemployment may prompt the U.S. Federal Reserve to lower interest rates this year to reboot growth. This may be a sharp change in monetary policy as rates have been kept strictly at 5.25 percent for 2007. Mathew Strauss, a senior currency strategist at RBC Capital Markets Inc. in Toronto, comments: “The payroll number raised concern that the slowdown in housing may start to affect growth. It seems one supporting factor for U.S. consumers may start to lose ground—a strong labor market.” Investors betting on futures contracts on the fed fund rate due in December changed forecasts on the yield to 5.02 percent, down from 5.21 percent from a month ago. The Fed will next meet on August 7^th.

Currency Outlook and Forecast:
The decisive factor for the future U.S. dollar movement is the subprime crisis. The big question bothering investors is whether the U.S. housing slump will spill over into the rest of the U.S. economy. Speaking on this issue, Jim Rogers, co-founder along with George Soros of the Quantum Fund, believes losses from the subprime-market have a long way to go. According to Rogers: “This [subprime defaults] was one of the biggest bubbles we’ve ever had in credit.” He forecasts U.S. investment banks and homebuilders will take further hits. Bear Stearns stock fell 13 percent last week. Shares in other investment banks such as Merrill Lynch and Lehman Brothers also fell this week.

Kathy Lien, chief currency strategist at FXCM, forecasts August to be a tough month for the U.S. dollar. She believes tighter credit and the housing blowup will have significant negative effects on the U.S. economy this month (see her article at dailyfx.com). Don’t expect steady long term gains in the dollar anytime soon, especially as the Fed may be lowering the borrowing rate later this year.

Global equities markets took a beating last week. The phenomenon began in the United States (on the back of subprime mortgage concerns) and it spread to the financial markets in other countries. For the forex market, the primary impact of the losses was a return of risk-aversion. The risk appetite of currency traders has waned, and as a result, the yen-based carry trade has begun to unwind. The US dollar has also appreciated significantly as investors run to the safety of US assets. But the search for yield and the changing fundamentals of the market complicate matters, and the current trends may not last.

Regarding the carry trade, it is risk aversion driving the FX market. Japanese fundamentals stink, with Retail Sales disappointing to the negative and deflation sill a concern. But the yen continues to gain as greater market volatility hurts the carry trade. But this is all dependent on the equities market. If the Dow recoups its losses this week, we will see a renewal of the yen carry trade.

The US dollar also saw some improbable gains this past weekend. With investors more conscious of risk, the stability offered by dollar-denominated assets is more appealing. Americans, concerned about losing their gains overseas, repatriate their holdings into US dollars. For international traders, the US dollar becomes a store of value, just like holding gold or silver. Emerging markets in Asia were especially hard hit as overseas investor sunned riskier assets in favor of American ones. This particular phenomenon is controlling the currency market, overpowering economic factors that would pull back the US dollar (like the disastrous Existing Home Sales report).

But the forex market changes very quickly, and if last week’s equities market decline proves temporary, then we could see both a resumption in the carry trade and a plunge in the US dollar. The yen already began giving back some of its gains in European and Asian trading this morning with EURJPY, GBPJPY, AUDJPY and NZDJPY all riding upwards. And the US dollar cannot maintain its status as a store of value forever.

The latter situation is pretty interesting. The dollar benefits from its use as the currency of choice in international trade and as the primary denomination in foreign reserves. We have talked in the past about how other countries are starting to move away from the US dollar both in terms of international trade and in terms of foreign reserves. And there are reports in Bloomberg today of increasing protectionism with regard to foreign ownership of assets in the United States and Europe. This hurts the dollar and the euro because it makes dollar- and euro-denominated assets less attractive. And US fundamentals do not look like they are going to get better anytime soon. A recent Fed report suggests that even the weak US dollar may not help the trade deficit. We may see temporary gains in the greenback and the yen, but a long-term outlook does not bode well for either currency.

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.

Yesterday’s report on the extremely sluggish U.S. housing market sent equities markets crashing, investors dumping corporate debt, and currency traders unwinding carry trades. New U.S. homes sales for June fell 6.6 percent. This number has jumped significantly from the 2.2 percent decrease in May. According to a Bloomberg article, this may be a no end to the real-estate slump. The housing issue has even breached the international level as a report today by the U.K.’s Nationwide Building Society showed home values to have risen only 0.1 percent in June, the slowest in 15 months.

The faltering confidence in the equities markets has also brought shifts in forex. Despite having been on a six-week run against the dollar, the pound took its biggest fall in the last five months. The pound dropped 1.0 percent in one day to $2.0305 at 1:04 p.m. in London from $2.0491 late yesterday. On July 24^th the pound had reached $2.0654, its highest level since May 1981. The pound and the euro also took major hits against the yen, indicating investors are losing confidence in their carry trades with the Japanese currency. Against the yen, the pound fell to 241.27 from yesterday’s close of 243.21. Steven Barrow, chief currency strategist at Bear Stearns Intl. Ltd. in London, states: “There’s a reasonable degree of panic going on with the whole mortgage and credit issue and that has encouraged risk aversion.”

Currency Outlook and Strategy:

The sharp fall in the pound has allowed the 14-day RSI for the GBP/USD to fall below 70. This indicates that a reversal will not come anytime soon. Kathy Lien, chief currency strategist at FXCM expects “room for more losses” in the pound. In addition, traders have taken steps to hedge against the risk of a rallying yen. The cost of options protecting against gains in the yen rose to a 3 year high. This movement of risk aversion indicates a revival in the carry trade may not happen anytime soon. Neil Jones, head of European hedge fund sales at Mizuho Financial Group Inc. in London, states: “Investors are looking for some short-term protection on their exposure to the yen strengthening.”

History has shown us an interesting pattern where the EUR/JPY pair has followed a very similar trend to that of the U.S. Dow Jones Industrial. As the Dow takes hits so does the EUR/JPY. See more on this pattern in an article by FXCM technical currency strategist Jamie Saettele. Overall, the leveraged-buyout financing era has taken a huge fall. There is much uncertainty as investors are shifting their portfolios toward less risky assets. Steve Pearson, chief currency strategist at HBOS Treasury Service PLC in London, reflects: “[The] three year period where financial market volatility has declined to low levels is over.” For now it is best to let the markets react and then change strategy.  

The GDP release for the second quarter came out strong this morning, printing at 6.4% annualized growth versus 3.2% expected. This was on top of a revised 0.6% pace for the first quarter of 2007. The dollar was already trading upwards early this morning and in European trading in anticipation of a positive release. EUR/USD had fallen as low as 1.3650, and it is hovering at about 10 pips over that right now. For a good primer on how you should trade an event risk like the US GDP report, try the GDP analysis on DailyFX.

US GDP rebounded for a variety of reasons. Rising exports, aided by the weak dollar, made up for the high input costs of $70 oil. There was a gain in commercial construction, balancing out the slump in the housing market. And finally, there was a significant rise in government spending last quarter, which probably cannot be sustained and certainly should not be counted on for future growth.

But the engine of the US economy is consumer spending, with consumption comprising 70% of GDP. And this sector only rose 1.3% the past three months, a troubling amount considering the 3.7% rise in the first quarter of this year. If the American consumer is tapped out, and that looks to be the case, then that does not bode well for growth the rest of the year.

The report this morning did beat expectations. And it probably fooled the traders in the Fed Futures market that have priced in a 90% chance of an interest rate cut by the end of the year. But economic prospects in the United States are not aligned for expansion either. Risk aversion seems to be killing the market (and the carry trade) as well. It is in times like these that it seems the best that individual traders can do is tread water. And that’s why managed funds seem so attractive. Most forex managed funds will not offer returns much different than mutual funds, but they do provide extra diversification important in market downturns. And one of the best that you might want to check out is called the Sentiment Fund by FXCM. Trading has been up and down in the forex market recently, and it’s hard for even the professionals to stay on top of things. And so it’s helpful to have an experienced hand at the top.

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.

Inflation has always been an important concern for currency analysts, if only because it has a direct relationship with interest rates.  Central banks have a mandate to keep inflation under control, and so signs of rising inflation indicate a strong currency.  But the new paradigm of an increasingly international economy could leave monetary policy makers impotent in the face of global inflationary surges.

Commodity prices are near record highs, and interest rates do not have the power to completely moderate supply-side inflationary pressures.  Oil is selling for almost $80/bbl, and there are market analysts who believe we are likely to see $100 oil by 2008.  That would put oil at the $100 level one full year before Goldman’s now infamous oil projections of last year.  Gold and food prices are also through the roof (they are the primary driver of high prices in Australia and New Zealand).  With growing demand for commodities from developing economies, price pressures are not in line to let up anytime soon.  In the forex market, the most prominent consequence of the commodity boom is the incredible rise of the three major commodity currencies (Canadian dollar, Australian dollar and New Zealand dollar).

But more troubling for fans of domestic monetary policy is that inflation is also being stoked by rising prices for finished goods and services.  This phenomenon has surprised many observers because it seems counterintuitive to the idea of globalization.  Free trade was supposed to lead to higher efficiency and lower prices.  But with emerging markets all over the world on the rise, we are seeing more and more wealth in the developing world.  A booming economy naturally leads to higher prices, and the Chinese yuan, Indian rupee and other emerging market currencies have appreciated significantly this year.  Goods from these countries are now more expensive, and so as we buy imports from the rest of the world, we see China and India and Brazil exporting inflation.

Growing wealth in the world’s developing areas has other consequences of inflation as well.  Rich foreigners buy assets in the developed economies, and more buyers drives up the price of these assets.  This is partly the cause of exploding real estate prices in London.  For those concerned about the US dollar, we should note that the weak dollar makes US assets especially attractive.  It is as if US products were being sold at a discount relative to prices in the past.  This is why foreign ownership of US securities reached record levels last May.  But forex traders should still keep track of the current state of the US dollar.  Traders like to invest in markets that are growing (and economies that are healthy.  So while a weak dollar might be good for the US economy, a weakening dollar is bad.  And with central banks less powerful in the face of the new global economy, we might not be able to do anything about it.

European Central Bank President Jean Claude-Trichet spoke to a group of students and economists recently on the “overwhelming success of the euro.” Europe as a whole is definitely going through a boom period right now with unemployment in the continent at a 25-year low and steady growth. Much of that success, Trichet claims, should be credited to the unified economic and monetary policy. I want to spend some time this morning talking about that assertion and how the euro has been good (and bad) for Europe.

Now the economic virtues of the European Union are numerous, but I want to just focus on the currency today. One of the advantages of the euro is that weak economies get to piggyback on strong ones. And by strong ones, I mean Germany. For the last 60 or so years, Germany has been the engine that drives European growth, and its currency, the Deutschemark, has been Europe’s most stable. What the euro does is it allows countries like Italy, which had a notoriously bad currency, to benefit from the international confidence in German stability. Germany’s reputation basically grants a halo effect to the rest of Europe. This is essential for the central and eastern European countries because as emerging markets, their currencies might otherwise be subjected to dangerous volatility levels.

Another benefit is the political independence of the European Central Bank. Before European monetary policy became aligned, the central banks of many countries were headed by the finance ministers in those countries. But finance ministers are politically appointed, and so the economic and monetary decisions were often dependent on political gain or loss. The independence of the ECB from European governments has allowed for more stability in monetary policy. This is an especially important front to pay attention to as French President Nicolas Sarkozy continues to push for more input from finance ministers. Let’s hope that ECB can withstand this misguided effort.

While the stable monetary policy has been mostly a good thing for Europe, it does have its share of problems. A unified monetary policy eliminates some independence for individual areas. If most of Europe is going through a bust cycle, the bank will lower interest rates. But if Belgium is experiencing growth, this decision will lead to inflation in Belgium.

One great example of this scenario is Germany after re-unification. The government faced a need to invest in what used to be East Germany, and increased investment led to inflationary pressures. The German government needed to raise interest rates to combat this threat. France faced no such threats, but had to raise interest rates as well to maintain the integrity of the fixed Exchange Rate Mechanism (ERM). The French economy experienced a recession, and plans for a unified monetary policy almost fell apart eight then.

This problem is evident today as well. Most western European economies are stable and developed. Growth is consistent, but not especially fast. Unemployment and inflation are usually at manageable levels. But the newer EU countries, those from Eastern Europe, are at a different stage in their economic growth. They are, as a whole, growing faster as developing countries. Ideally, the different parts of Europe would have different monetary policies to accommodate the different conditions, but the euro would make that impossible. Sharing a currency means sharing a monetary policy. So while the euro is mainly a good thing, it might not be a good thing for everyone involved.