The U.S. dollar has weakened significantly driving many of the major currencies to the highest level in months. Here’s a table illustrating the significance of today’s moves. I expect at least another 2 percent decline in the U.S. dollar against the key currencies (Short and Long Term Outlook for U.S. Dollar).
The fact that USD/JPY is not participating in today’s rally indicates that investors’ distaste for dollars rather than their risk appetite is driving the dollar lower. The modest gains in Dow futures and the sharp rise in gold prices confirm that investors are bailing out of dollars. In my interview with Fox Business 2 days ago, I talked about how the one takeaway from the concern about the credit worthiness of the U.S. is the need for diversification.
Yesterday, a Brazilian official said that the BRIC nations (Brazil, Russia, India and China) could take unilateral action to reduce their dependency of dollars at their summit next month. Brazil has already begun to replace the dollar bilaterally in their trade with China and unfortunately this trend could continue with other nations following suit in the coming weeks and months. The one thing that the financial crisis has taught investors large and small is need for diversification and no one wants to sit with baskets full of dollars waiting for S&P to make an announcement. Sovereign Wealth Funds are taking this to heart which could create a fresh supply of dollars.
The EUR/USD is on a tear, having rallied more than 600 pips or 5 percent over the past 24 hours. The significance of Fed’s actions continue to resonate over the currency markets and even though we have already seen parabolic moves in the pair, I think it will head higher.
On December 16th, when the Fed first brought up the prospect of buying U.S. Treasuries at their FOMC meeting, the EUR/USD rose from a low of 1.3629 to a high of 1.4719, an 8 percent move. Now that the Fed is actually following through with buying longer term Treasuries, the impact on the EUR/USD should be the same if not greater.
We have seen a similar reaction in the British pound. After officially announcing Quantitative Easing, the GBP/USD fell 650 pips, a move of only 4.5 percent. However the price action of the GBP/USD has been diluted by the weakness of the greenback and so a more accurate reflection of the market’s appetite for British pounds post Quantitative Easing can be found in EUR/GBP which has rallied 8 percent since the March 5th Bank of England meeting.
Therefore an 8 percent move in the EUR/USD post FOMC would take the currency pair to at least 1.40 from Wednesday’s low, which is my target over the next few trading days.
EURO BREAKS 1.40 HOW MUCH FURTHER CAN IT FALL?
The Euro broke 1.40 following the Reserve Bank of New Zealand interest rate decision as traders realized that the European Central Bank could cut interest rates over the next few months. Despite the hawkishness of ECB President Trichet, it should just be a matter of time before he gives in and cuts interest rates as well. For some investors like central banks who have deep pockets, EUR/USD at 1.39 may be a value play. But even if we see a relief rally in the EUR/USD, don’t expect it to last because the break of 1.40 could trigger a flush down to 1.39. On a purchasing power parity basis, the EUR/USD could fall as low as 1.15.
3 Factors Driving the EUR/USD Lower
1. Oil Prices Fall Despite OPEC Cut: There is a 70% Correlation between EUR/USD and Oil YTD
2. European Commission Slashes Eurozone Growth Estimates, Rate Cuts Anticipated
3. Risk Aversion: 1 Month ATM EUR/USD Volatility Hits Highest Level Since September 2001
Since the beginning of the year, there has been a 70 percent correlation between the price of oil and the EUR/USD. With crude prices edging lower despite a production cut by OPEC, the correlation with oil is a big reason why the Euro has broken 1.40. The European Commission also downgraded the Eurozone’s GDP forecast. The sharp drop in German exports suggests that the country could fall into a technical recession next quarter. Despite the problems, the growth story still favors the US over the Eurozone.
Volatility at 7 Yr High
One month at the money EUR/USD volatilities also hit the highest level in 7 years. Volatility peaked at 14.55 in the EUR/USD days after the 9/11 attack. We are faced with sharp volatilities once again with ATM 1 month vols at 12.63. High volatility tells us that the currency markets are still nervous but periods of high volatility usually precede periods of lower volatility. Back in 2001, after volatility peaked, the trading range in the EUR/USD contracted by 50% – that range lasted for 8 months.
Eurozone Needs a Weak Euro
The weakness of the Euro should be comforting for the European Central Bank because it is the answer to many of their problems. As an export dependent region, the slide in the Euro will help to support the economy, just like the weakness of the US dollar has contributed to corporate profitability. The Eurozone can also handle a weaker currency at this time because oil prices have fallen materially. Therefore don’t expect the ECB to stem the currency’s fall. We still believe that there will be further losses in the EUR/USD but not beyond 1.35.
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