Foreign Exchange... Problems In Europe We maintain our generally bullish view of the dollar. We appreciate the global imbalances, to which the G7 has alluded again this weekend, and are fully mindful of the risks posed by the US current account deficit. Indeed, this may yet return to haunt the dollar at some future point. For now, though, the shortfall is being comfortably financed.
As we said last week, the 1.2200 level for EUR/USD proved to be important. The break below this point, which sat on a three month upward sloping trendline, triggered the decline to the current level of 1.2040, and we expect a further move towards the July low of 1.1900. Now this level coincides with the neckline of the major head and shoulders reversal pattern, about which we have been harping on for several months. If 1.1900 gives way, EUR/USD is heading towards 1.1500. Judging by the relative strength indices (RSI) of the short, medium and long-term charts, 1.1900 could well hold initially, leading to a brief euro bounce before the dollar reasserts itself.
From the US perspective, the fact that the Federal Reserve upped interest rates by a further 25bps to 3.75% while the southern states of the country are still reeling from Hurricanes Katrina and Rita is a clear indication of future central bank policy. More rate hikes are coming to fend off short-term inflationary pressures from high oil prices and a generally buoyant US economy. Sure, upcoming consumer confidence and employment numbers are likely to be weak, but the underlying momentum of the economy prior to the hurricanes should ensure a rebound in early 2006, boosted no doubt by the reconstruction effort.
As for euroland, we are still somewhat concerned by poor economic growth and a certain degree of political instability. With regards to the economy, real GDP growth has consistently lagged that of the US over the past few years, averaging just 1.5%, with a figure of 1.3% expected for 2005. Earlier in the year, we were a little critical of the ECB for not lowering the refinancing rate to stimulate domestic demand. Given the inflationary pressures of higher oil prices, this window is seemingly shut, and in fact the next move in rates could well be on the upside, although unlikely for quite a while yet. In fairness to the ECB, it has stuck to its guns of price stability, and it could be argued that a small rate cut without the necessary structural reform would have been largely ineffective. That said, we do feel that the European central bank is somewhat overly concerned by money supply data at the expense of a more vibrant economy. In this respect, comments on Saturday by Erkki Liikanen, a member of the ECB’s Governing Council, seem rather extreme. He claimed it is vital that Europe ensures that inflation expectations are anchored so as not to face a 1970s-style bout of price and wage rises. Reasonable concerns, of course, but hardly a likely scenario at the moment, with CPI running at around 2.1% y-o-y. Furthermore, higher interest rates would hardly be welcome in Germany or Italy at the present time.
On the political front, the uncertainty in Germany following the results of last week’s elections leaves the reform process up in the air, for now at least. The prospects of a grand coalition have increased, although both Chancellor Schroder and Angela Merkel are keen to lead such a coalition. In Italy, Finance Minister Domenico Siniscalco has resigned, due to lack of action over the ongoing banking scandal. This puts the government under further pressure in the run-up to finalisation of the budget, and creates more uncertainty in the country ahead of next May’s general election. On the wider issue of the EU constitution, rejected so emphatically of course by France and Holland earlier in the year, EU leaders have declared that a new one may be years away.
Back to exchange rates, the dollar is also looking strong against sterling and the yen. With regards to the former, the UK consumer is still in retreat, while the IMF recently suggested that UK real GDP would grow by just 1.9% this year, compared to the Chancellor’s expectations of around 3.0%. The loss of tax revenues will hit budgetary forecasts, which probably means one thing. Indirect taxation is on the rise, again. As for USD/JPY, a move through 112.80 would signal a rally towards the major 113.70 resistance area. This is key. Any break higher could well presage medium-term gains towards 120.00.
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