| Diverging fortunes for the euro |
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David Powell assesses the impact of fluctuation in the euro, US dollars and sterling – and its effect on the Irish business community.
Powell writes, 'a continuation of monetary easing in the UK would cause the yield spread between the euro and the pound to move in favour of the single currency, leaving EUR/GBP to post new record highs in the year ahead. Indeed, we expect this European cross to hit 0.8400 by the end of 2Q 2009 before retreating to end the year at 0.8200.' |
More than 300 years have passed since Sir Isaac Newton first published his monumental book, Philosophiae Naturalis Principia Mathematica, in which he put forth his famous law of gravity. Nonetheless, his conclusion of ‘what goes up, must come down’ is as true as ever, particularly in the foreign exchange markets. On the other hand, one should remember the famous words of another great physicist, Albert Einstein: ‘It’s all relative.’
In the weeks leading up to EUR/USD posting a new record high in July, the signs of an imminent reversal were becoming increasingly apparent; the eurozone economy was clearly experiencing a sharp economic slowdown and market expectations for additional monetary tightening from the ECB were looking unfounded, suggesting a deterioration in cyclical support for the single currency. In addition, the large capital inflows that helped the euro climb the mountain of extreme overvaluation had shifted to modest outflows in recent months.  | | David Powell |
Every currency pair naturally reacts to the developments of the two economies involved, and the monetary policy outlook for the Federal Reserve also played a role in the dollar’s climb. Having been the first central bank amongst the world’s developed economies to cut interest rates in response to the threats to the domestic economy posed by the credit crunch, the dollar experienced a period of significant weakness in the second half of 2007 and particularly the first half of 2008. With interest rates well into stimulative territory, the Fed will have to eventually remove its monetary accommodation in order to normalise conditions. Indeed, Bank of America economists expect the Federal Reserve to start raising its key interest rate, the Fed Funds target, in 2H 2009. Expectations for increased yield support relative to the euro supported the dollar in the early stages of the greenback’s summer rally and should continue to do so next year. We look for EUR/USD to end 2009 at 1.3600. This may not seem like much of a rally with EUR/USD having already traded below 1.35900 in early October, but we view the most recent leg of the dollar’s surge (when EUR/USD tumbled from 1.45 to 1.35) as unsustainable and look for EUR/USD to rebound over the next quarter.
The world changed during the first week of August, including some key relationships in the currency markets. While many watched the beginning of the summer Olympic Games in Beijing on Friday 8th August and Russian troops marched across the Georgian border to reoccupy old territory, the dollar was also storming ahead to recapture formerly held ground. ECB President Trichet helped plant the seeds for the dollar surge on the previous day by dispelling any lingering thoughts that the Eurozone economy would decouple from the slowdown in the US. At the monthly ECB press conference, he acknowledged that the Eurozone was indeed facing a period of lower growth, effectively nailing shut the coffin of the decoupling story. Until this point, the reduction of risk had generally been a negative factor for USD, which had been weighed heavily upon as worries surrounding the health of the US banking system increased and the Federal Reserve cut interest rates. However, when it became clear that the rest of the world’s industrialised countries were experiencing a major slowdown in growth, global fund managers likely undertook a significant shift in asset allocation and liquidated large positions in non-USD denominated investments, creating a large safe haven bid for the greenback. This was followed by a short period of appreciated for EUR/USD in mid-September as the dollar started to ‘recouple’ with the weak fundamentals of the US economy. However, the dollar then experienced a second significant boost in late September due to a severe USD liquidity shortage around the world, with USD Libor surging.
A false economy?
The new found strength of the USD should not however be mistaken as confirmation that the US economy is now on a firm path to a sustainable recovery. The US economy expanded at an above trend annualised rate of 2.8 per cent in the second quarter of this year, but the boost from the US government’s spring fiscal stimulus plan will likely continue to fade at the same time as the contribution from exports declines with the slowing growth of major US trading partners. Indeed, the three month moving average of the Chicago Fed National Activity Index was at -0.80 in July, marking the fifth consecutive month under the -0.70 level identified by the Chicago Fed as recessionary territory. The latest data from the US for the month of September does not offer much encouragement, with the employment rate remaining at 6.1 per cent versus a recent low of 4.4 per cent in March 2007. Indeed Bank of America economists look for GDP growth to slow to the 1.04-0.0 per cent range during 2H 2008, with negative growth into early 2009. We expect the disequilibrium between the value of the USD and the health of the US economy to eventually correct itself and look for EUR/USD to end this year around 1.4500.
The descent of EUR/USD in 2009 from its late 2008 rebound should also be supported by monetary easing in the Eurozone. The ECB joined the chorus of global central bankers who cut interest rates by 50bp on October 8th as the financial crisis intensified, and opened the door for further rate cuts, despite fears about increasing labour costs in Germany, Italy and Spain. Indeed Bank of America economists look for the ECB to cut rates by an additional 75bp by next Spring.
The value of the euro versus the dollar is, of course, a matter of great importance to the Irish business community, with 39 per cent of the country’s non-eurozone exports shipped to the US. However, the euro’s value versus the pound is also of vital importance, with the UK absorbing 30 per cent of Ireland’s exports. Importantly, the outlook for the euro versus the pound differs significantly from the single currency’s projected path versus the dollar.
Central bankers in the UK will likely need to ease monetary policy more aggressively than their counterparts in Frankfurt. The British economy is facing the most difficult times since the 1991 recession under the pressure of the credit crunch, falling housing prices and a deteriorating labour market. While UK inflation will probably peak in the third quarter of this year, the Bank of England’s MPC will likely focus on the deflationary aspects of the present economic slowdown and is expected to continue easing monetary policy in November (by 25bp), and cut its key rate by a total of another 125bp by 3Q 2009. A continuation of monetary easing in the UK would cause the yield spread between the euro and the pound to move in favour of the single currency, leaving EUR/GBP to post new record highs in the year ahead. Indeed, we expect this European cross to hit 0.8400 by the end of 2Q 2009 before retreating to end the year at 0.8200.
Former Federal Reserve chairman Alan Greenspan once admitted that ‘having endeavoured to forecast exchange rates for more than half a century, I have understandably developed significant humility about my ability in this area.’ While most currency strategists would be the first individuals to admit that foreign exchange forecasts involve a degree of uncertainty, there would be enough humility to go around for the financial market participants who do not plan for the diverging fortunes of the euro relative to the USD and relative to the GBP. |
David Powell is G10 Currency Strategist at Bank of America in London.
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