Category — Western Europe

It is not easy for many to admit that they made an error. It seems the President Trichet might finally be starting to embark on that difficult path. After raising rates in the Euro-Zone over the protests of many top figures within that continent, Trichet finally admitted what the rest of the world had realized some time ago: the Euro-Zone’s growth prospects are weak. This announcement/confession reflects that the ECB is starting to question if it did the right thing in raising rates. By hiking interest rates, the ECB indicated that it believed that growth would not be hurt too much by their inflation-targeting movements. It seems as though they were mistaken.

While admitting a mistake is a rarity for many, it seems that is even less frequent for public figures. Powerful men and women at the top of their fields have usually ended up there by making correct decisions, and so the idea of messing up can seem foreign. However, with the future health of the European economy largely riding on the ECB’s next move, it is time to these men and women to bite the bullet and cut rates. By alleviating this pressure the ECB will, among other things, send the message that they take growth very seriously and are committed to the economic prosperity of the European Union.

While inflation is very important, the ECB should currently direct its focus towards growth. Inflation targeting is not a cure-all, and if attacking inflation includes the ruin of the Euro-Zone’s economy, then that does not strike me as very helpful.

Upcoming Figures
EUR German Gross Domestic Product (2Q)
EUR German Consumer Price Index (Jul)
EUR French Gross Domestic Product (2Q)
EUR Euro-Zone Gross Domestic Product (2Q)
EUR Euro-Zone Consumer Price Index (Jul)
USD Consumer Price Index (Jul)
NZD Retail Sales (Jun)

One of the interesting aspects about today’s country in the Random Country Report is its youth; the country abandoned communism less than twenty years ago. Hungary, like many of neighbors, is a relatively young republic, and while many countries have had centuries to adapt to capitalism, Hungary has had about eighteen years to acclimate to a free market. Considering that with the fall of communism, Hungary lost – seemingly overnight – access to about ¾ of its export market, one has to be impressed with the strides that the country’s economy has taken.

Hungary, now firmly a “second-world country,” is a member of European Union (since 2004) and the World Trade Organization. It is on track to have access to the Euro by 2012, slowly approaching the conditions of the Maastricht Treaty. Their current currency, the Forint, trades at around 144 Forints to 1 US Dollar, demonstrating the importance of adopting the Euro (a much stronger currency). Though the currency was pegged (in the 1990’s) to a basket of various currencies, the Forint is now a floating currency. Having experienced tremendous growth for years, Hungarian GDP has slowed recently, yet is expected to pick up soon.

While Hungary, like many countries emerging from the Soviet Bloc, relied on IMF funds for some time, they have paid off all of their debts to the Fund. The country is very attractive to foreign investors, given its location (situated between Central and Eastern Europe), its educated and skilled workforce, and its exchange rate, among other factors. As a member of the European Union, there are also significant advantages for foreign investors.

The outlook for Hungary is unclear. While membership to the EU is a positive step, the country needs to make significant improvements in order to be able to use the Euro. In order to meet the rigid standards, Hungary might have to make unpleasant decisions relating to its economy. For example, they might have to attack inflation aggressively in the obligatory attempt to halve it within the coming years; this could facilitate poor growth. Still, I am guardedly optimistic about Hungary’s long-term prospects as many of their strengths are areas unlikely to change, such as foreign investment, tourism, and political dedication to pursuing free-market policies.

Upcoming Figures
JPY Leading Index (May)
CAD International Securities Transactions (May)
USD Housing Starts (Jun)
USD Philadelphia Fed Manufacturing Survey (Jul)
CAD Bank of Canada Monetary Policy Report
JPY BOJ to Publish Minutes of Board Meeting (Jun 12-13)

With this week’s ECB’s decision all but official, a more important question looms: what’s next? The ECB is a bank whose primary focus – witnessed in both its charter and its past actions – is price stability. Despite poor economic performance in recent months, the ECB essentially has to raise rates this week, as the Euro-Zone’s current inflation level is double the target of 2%. While President Trichet and his peers may pray that a single, small hike will be enough to curb rising inflation, the more likely scenario is that the policy move will not have a huge effect. So, the question remains: what’s next?

What’s next is a big decision. The age old debate (or as old as central banks have existed) between pursuing policies that facilitate growth or inflation is front and center in many prominent economies around the globe, and Europe is no exception. Rising energy costs have not helped the problem, leading some analysts to publically worry about stagflation rearing its ugly head. In a perfect world, high growth rates allow central banks to raise rates in the never-ending war on inflation (e.g. Australia). However, growth is unquestionably slowing all throughout Europe, and many fear that a rate hike could severely impact many of the smaller economies in the Euro-Zone.

In the long-run, Trichet (or whoever is in charge of the ECB in the future) has no choice; the ECB must focus on price stability first and foremost. However, in the next six months, what the ECB will do is anybody’s guess. One popular school of thought is that the ECB will employ a wait-and-see attitude; they will raise rates now and then observe the resulting economic data for a few months. Others feel that the ECB’s mandated focus on inflation will lead to a series of hikes, regardless of the costs. For many years, West Germany’s Bundesbank produced astounding economic prosperity, a result that many attributed to the Bank’s dedication to price stability. The ECB is a descendent of the Bundesbank, and so in my mind, I think that the ECB will not be done raising rates for the year after this week.

Of course, they could shock the world and not raise rates. You never know what will happen in the world of foreign exchange…

Upcoming Figures
AUD Reserve Bank of Australia Rate Decision
USD ISM Manufacturing (Jun)
USD ISM Prices Paid (Jun)

In some weeks, the news highlight in the FOREX world is an Italian report on car sales. Other weeks, the major headline is that Nigerian workers are striking against the oil companies. However, this week, there’s plenty to be excited about, especially the most important gathering since the meeting of the Five Families: the U.S. Federal Reserve Open Market Committee Meeting.

Ladies and Gentlemen, start your engines.

Ok, perhaps this is not quite as important as Don Corleone and Co., but in the FOREX world, there are few planned events that can have as much impact as this one. Ever since Fed Chairman Bernanke announced an end to rate cuts a few weeks ago, anyone and everyone has circled this week on the calendar. Most analysts, traders, and “people in the know” are not anticipating a rate change, which would be the first time that FOMC has met and not done so in some time. However, despite a general sense of confidence that rates will be held constant, everyone connected to the market will be reading between the lines to try and get a glimpse of the Fed’s future moves.

With energy costs going nowhere but up, it has been argued that the Fed’s main concern might be that issue instead of their stated focus: inflation. Should the meeting’s outcome go as forecasted (no rate change), that would be a signal that inflation is not the only problem that the Fed is attempting to solve. If inflation is rearing its ugly head, the standard call out of the Central Bank’s Playbook has been to raise rates. However, there is a general worry that such a hike would only aid energy prices in their climb. As a result, most are predicting that the Fed will stand pat for now.

Though not this week, the ECB will be meeting soon, and will face a tough decision of their own. While the Fed only said that they are done cutting rates, the ECB has stated that they plan on raising rates. The problem with President Trichet’s plan, however, is that the economic data reported since that announcement has indicated that a rate cut might not be the smart move. Growth in the Euro-zone is slowing, and unless Trichet wants to play chicken with the economy and see who backs down first, a rate cut is being seen as less and less likely. However, Trichet is considered one of the most hawkish heads of a central bank in the world, so anything is possible.

The European Central Bank and the United States Federal Reserve are bailing out the financial markets right now.   BNP Paribas declared that they are suspending withdrawals from three of their investment funds, and the market reacted pretty poorly.  The overnight lending rate for euros shot up to 4.7%, leading the ECB to distribute over 155 billion euros over the past two days.  The Fed, which has seen two straight days with the LIBOR rate above the benchmark rate of 5.25%, has added $43 billion in temporary cash.  The Bank of Japan and the Reserve Bank of Australia, this morning, added $8.5 billion and $4.2 billion, respectively.

Risk aversion has been on a steady climb recently, and naturally, the demand for liquidity has skyrocketed.  Central banks around the world have used their tools to ameliorate the crisis.  The real problem is what message this sends to participants in the financial markets, whether it be equities or foreign exchange.  The last time there was a bailout this large was right after September 11, 2001.  Earlier this week, both the ECB and the Fed were talking about how credit conditions were manageable.  The Reserve Bank of Australia raised its interest rate to 6.5%.  The Bank of England basically came out and said that they were ready to keep raising interest rates for the near future.  What do the central banks know now that has caused them to change their positions?  And what do the commercial banks in Europe and America know that led them to accept the loans?  Is the US subprime crisis a worldwide issue now? Bear Sterns Chief Financial Officer Samuel Molinaro came out and called this the worst fixed income market that he has ever seen.  And the primary driver for investors is fear, fear of what the answers to those three questions are.

It would be a different scenario if it was only firms on Wall Street losing money.  It would hurt the US economy, but the influence would be limited.  But what a liquidity crisis means is higher interest rates.  For everyone.  Analysts across the spectrum have been chirping about how the era of easy money is over.  There are billions of dollars worth of adjustable rate mortgages that still need to be re-priced according to current interest rates in the coming months.  The housing situation is on track to get worse, with foreclosures even higher than before.  About seven million Americans are slated to lose their homes.  And with homes so important to personal equity and wealth, the problems will stifle individual growth and consumer spending.

In the short-term, the US dollar actually benefits from market uncertainty.  Risk aversion and volatility (Chicago Board of Option VIX survey is at a 4-year high) lead traders to park their assets in US dollars.  Counterintuitively, the US subprime crisis puts support under the US dollar.  But it’s time for the Fed to ease credit.  What has been done so far is not enough, and interest rates have to be lowered; money has to be thrown in to the financial markets.  The lower interest rates will counteract the safe haven status of the US dollar for now, but it is what is needed for the US economy to get through this situation.  Lower interest rates and greater liquidity will hurt dollar bulls in the short-term, but they will benefit the US economy (and therefore the US dollar) in the long-term.

The carry trade is not back. At all. Stay away for right now. The Dow rallied to close 150 points higher yesterday, and yen crosses followed that stock market rally. The high-yielding currencies, especially, made back a lot of their losses. But the upward movement is likely to be temporary because the current market is not conducive to the carry trade.

Volatility is still significant (the stock market may have ended in positive territory, but it wavered back and forth throughout the day). Risk aversion in the market is at a high level. This is the reason that US Treasuries continue to do well; the bonds gained 1.6% last month, second-best performance of all major international government bonds. And then there are the comments yesterday out of China threatening to dump dollars in response to protectionist legislation in the United States. No rational observer of the market actually thinks this is a likely possibility, but the chance is there. If nothing else, the proclamation by the government researcher reminded investors (in the forex market and elsewhere) of the potential power that China holds to disrupt international financial markets. And the fact remains that we do not have a long-term record to rely on of responsible financial administration out of China. The more people are afraid of risk, the worse the carry trade does.

The carry trade is a complicated proposition for anyone participating in the FX market. That’s why so many people get it wrong all the time, including those who make their living trading the currency. There’s so much information bouncing around the market, and traders are relying on fundamentals and technical analysis and have trouble deciding when different signals suggest different actions. As sacrilegious as it might sound, traders might actually be relying on too much information.

The great thing about the internet is it brings real-time news about everything right to our fingertips. But too many choices (for a trader) can actually be a bad thing. There’s a book out right now called The Paradox of Choice, and it’s about how, at a certain point, more options actually reduce the amount of choices available for an individual. We are paralyzed by the sheer number of things that we look at, and so we are unable to focus (or choose) the most valuable information. Bringing it back to the carry trade, the important observation to keep in mind is the following: carry trade thrive on three market conditions: (1) low volatility in international financial markets, (2) cheap money (or credit) and (3) a strong risk appetite among investors. The carry trade will not rebound because none of those three conditions are met in the current market climate.

The FX trading last night is evidence of this point. EUR/JPY, which has acted as a proxy for carry trade popularity, lost 200 points. The Swiss franc gained support through both a run away from the carry trade and a run toward safe havens. The high yielding currencies will continue to lose ground as both phenomena continue. USD/JPY will be the one of the few yen crosses to buck the trend because of the US dollar’s status as a store of value and a safe haven. But that is an abnormality and should not fool traders into thinking the carry trade is back.

The state of the US economy is not dire, but it certainly does not bode well for the US dollar.  Job creation was at its lowest level since February, with the NFP printing at an abysmal 92K.  But even worse for the dollar is the fact that job numbers are not the cause of growth or decline in the economy.  Payrolls are a reflection of demand; as house prices depreciate and take personal income down with them, that creates less of an incentive for businesses to grow.  In recessionary times, businesses are always slow to cut jobs, as the fall in labor always lags behind the fall in production.  The chance of a US recession will lead the greenback to fall against all the other major currencies.

As of right now, however, the idea of a recession is a little overstated.  But even if the economy is only stumbling (and will pick up later in the year), the US dollar is still going to take a hit.  That is because in this current market, equities are on line to fall even further.  US stocks have already been underperforming for years now compared to foreign equities markets.  And with fixed income in the United States more and more attractive because of the rising risk aversion among traders, that phenomenon is only going to continue.

Even the Fed policy meeting on Thursday is not likely to improve the mood of traders or dollar bulls.  That interest rates will stay the same is a market consensus, and Bernanke seems less inclined than his predecessor to act as a stock market savior.  The “Greenspan Put” should be pronounced dead, and forex observers can expect the announcement on Thursday to remain hawkish on inflation.  The futures market is pricing in a 100% chance of an interest rate cut in early 2008, but I believe the Fed funds rate will remain at 5.25% through the end of 2008.

The problems in the US housing market are a concern, however.  American Home Mortgage declared bankruptcy this morning, becoming the second-biggest lender to do so amid the subprime fallout.  Bear Sterns continues to take hits, with S&P announcing a negative on its debt rating.  The primary beneficiary of the weakness in US assets is the euro.  Ever since its inception, the euro has acted as the anti-dollar, providing an alternative for currency traders soured on the US market.  That is certainly the case right now, as euro bulls are having a field day.  Look for EURUSD to test 1.3900, and if it can overcome the resistance there, then the pair should see clear sailing through 1.4000.

After the euro, the other major currency to benefit in this forex climate is the Swiss franc.  Look for the Swissie to be the biggest gainer against the US dollar this week.  The low-yielding currency has found support as the carry trade has unwound.  As painful as carry trade unwind has been for those shorting the franc, history tells us that we are not even close to done yet.  The franc already hit a two-year high against the US dollar early this morning, with USDCHF reaching 1.1868.  The Swiss franc is both a growth story and a safe haven in a time of risk aversion, making it extremely attractive to currency investors.

The US Non-Farm Payrolls report disappointed the forex market this morning, listing only 92K new jobs.  We should have expected this based on the dreadful ADP survey, but ADP has a history of missing the mark on Non-Farm Payrolls.  And so economists were actually expecting 127K new jobs, and the US labor market did not deliver.  With less than 100K new jobs, the NFP puts the Fed on track to cut interest rates in early 2008, which may benefit the equities market when it happens but it kills the US dollar in the meantime.

The US dollar has benefited from risk aversion recently (or at least been sheltered from the turmoil in the equities markets) by its status at a store of value.  People find US assets safe, and so those traders invested in riskier environments (the carry trade) have parked their money in dollar-denominated assets for the time being.  But the euro is also safe, and right now there is great opportunity to trade EURUSD with this morning’s jobs report.  A general description of how that trading should be done can be found on DailyFX.com.

The important thing to consider is that most currency traders had already priced in high expectations for US payrolls.  Had the economy met those expectations (or even exceeded them) the market would have just yawned.  But the downside disappointment is surprising and so the negative FX reaction to the NFP should be steep.

The foreign exchange market should not destroy the US dollar, at least in the short-term, because of the inherent value that many traders place in the stability of the US currency.  But the American economy is reeling from the housing and mortgage crisis (exacerbated by the falling stock market), and the news will provide impetus for many traders to move out of dollar-denominated assets.  One place to move into is Europe, because as Kathy Lien of FXCM notes, the surprise press conference for the ECB yesterday almost certainly confirms an interest rate hike in September.

Jim Rogers, the man who made billions with George Soros in the 1980s and correctly predicted the commodity boom in 1999, calls the US housing market one of the biggest credit bubbles ever.  The US economy may not be able to just absorb the shock and move on.  Manufacturing will not be able to sustain its strength forever.  There are even reports in Bloomberg that risk appetite is returning to the market.  If this continues, then the US dollar will fall even more, as the ability of US Treasuries to store value will no longer be as prized.  There does not seem to be much good news for dollar bulls in the current FX environment, and the future does not look much brighter.

In the past week, EURUSD has lost more than 200 pips from its record highs.   But recent evidence shows signs of a retracing, with support for the euro regaining strength.  But it’s not like currency traders have fallen back in love with the euro.  Most of the movement in the currency pair in recent days has to do with softness in the US dollar, rather than any inherent strength in the European currency.

The data emanating from the continent is contradictory, to say the least.  Recent sentiment reports in Germany and France have bordered on terrible.  Retail Sales in Germany printed last night at a disappointing gain of 0.7%, versus 1.2% expected.  But unemployment fell by 45K, bringing the unemployment rate in Germany to 6.3%, the lowest level in that country in 14 years.  The forex market, understandably, is perplexed as to do what to do with this information.  And so trading in EURUSD right now consists of range trading within 40-60 points, with a market consensus of about 1.37.

The fundamental status of the US dollar is important in this situation because the euro is where the forex market likes to register its response to status changes in the greenback.  But even considering that, there’s no real direction for the currency market to follow.  The PCE deflator was released this morning, and the inflation register came in at 1.9%, excluding most food and energy costs.  This fits into the Fed’s comfort level of 1-2%, but the PCE deflator has a tendency to understate inflation.  Along with that, consumer spending met expectations with a gain of 0.1%, but the pace of growth is the slowest in nine months.  Home prices are also a concern, with the S&P/Case-Shiller index reporting that home prices in 20 US cities fell 2.8% in May—the biggest fall in more than six years.  But those negatives are tempered by the fact that disposable income in the United States rose 0.4% last month, outpacing spending for the first time in months.  The forex market did what it usually does with conflicting data like this: nothing.  The dollar barely moved at all against the yen and the euro after the release of the government report.

Currency traders may be confined to range trading in the near future, especially when it comes to EURUSD.  If you had to choose between the euro and the dollar, however, then your safer bet would be to go for the euro.  The ECB is only charged with maintaining price stability while the Fed has a dual mandate of controlling inflation and promoting growth.  Because of this, the ECB is likely to raise interest rates in September despite French President Nicolas Sarkozy’s concern for the negatives of a strong currency.  In contrast, chances are good that the US Fed will lower interest rates by the end of this year.  And so yield-hungry currency investors will abandon the dollar and flock to the euro.

One way to capitalize on this flow is to invest in a managed currency fund.  Bloomberg reported this morning on record returns achieved by these funds this year, and they are an excellent way to diversify your portfolio.  There are a number of very good funds out there right now, and one of the best in FXCM’s Sentiment Fund.

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.