Euro Hits 1 Yr Low on Trichet’s Comments: Is He Open to Coordinated Easing?

The European Central Bank President has finally buckled under the weight of bank failures, recessions and slower global growth. Although the ECB left interest rates unchanged at 4.25 percent this morning, Trichet has paved the way for an interest rate cut before the end of the year. This has driven the Euro to the lowest level against the US dollar in more than 12 months and the lowest level against the Japanese Yen in more than 2 years. It is important to realize that this is a dramatic departure from the Trichet’s stubbornly hawkish stance, especially since he raised interest rates as recently as July. It also suggests that he may not be opposed to coordinated easing. If the US bailout plan fails to stabilize the markets, central banks around the world could cut interests at the same time, which would send a strong message to investors and put an end to the weakness in equities.

Unfortunately Trichet had no choice but to be more dovish given the fact that there were 3 separate bailouts in the Eurozone (Fortis, Dexia and Hypo Real Estate Group) and Ireland has fallen into an official recession with Spain and Germany are expected to follow suit.

Only 2 Options – Keep Rates Unchanged or to Cut Them

It was only a matter of time before ECB President Trichet acknowledged the slowdown in growth especially as members of the region struggle with recessionary conditions. In fact, more specifically he indicated that the downside risks have increased and the turmoil in the financial markets complicates their near term outlook. On inflation, the drop in oil prices has allowed him to finally say that there has been a reduction in upside price risks.

In general, Trichet is not a fan of surprises and if he plans on cutting interest rates, he usually tries to prepare the market for the cut by adopting a slightly more dovish tone – which is exactly what we saw today. At the meeting, only 2 options were discussed, leaving interest rates unchanged or cutting them. Raising interest rates is out of the question.


ECB Could Cut Interest Rates by 100bp

The market is currently pricing in 100bp of easing over the next 12 months. The potential expansion in interest rate differentials between the Euro and the US dollar should continue to add pressure on the EUR/USD. The next major support level is not until 1.35.

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Could 1 Euro Equal 2 US Dollars?

The fourth time is the charm for the Euro as it finally pierces the 1.60 level against the US dollar. Despite slightly better than expected existing home sales in the US, a rebound in house prices, and news that the German Banking Association bailed out Duesseldorfer Hypothekenbank AG after a string of mortgage losses, the market refuses to give up its voracious appetite for Euros.

The latest bout of Euro strength or dollar weakness can be partially attributed to the sharp rise in oil prices, which hit $118.36 a barrel this morning. Before you know it, oil prices could be trading at $125 a barrel. This continual rise in inflationary pressures raises the risk of a rate hike from the European Central Bank.

This morning, ECB member Noyer said that the central bank will do what is needed to control inflation, including raising interest rates. Although he tried to temper that comment by saying that rates are currently appropriate, the seed has been planted.

Where is the Euro Headed Next?

Although 1.60 is a psychologically important level, it will not mark the end of Euro strength and dollar weakness. Speculators will continue to take the currency higher until ECB starts to wince. Unfortunately that may not come until another few hundred pips.

Don’t expect any verbal intervention from the ECB, let alone physical intervention anytime soon. Economic data has been stable allowing the central bank to bask in the benefit that a strong currency has on inflationary pressures. The next best alternative to combating inflationary pressures would be to let the currency continue to appreciate.

Whether or not the dollar’s weakness and the Euro’s strength can be sustained will be dependent upon who shocks the market first – the US or the Eurozone.

Next week the Federal Reserve will be meeting to decide on interest rates. If they cut by only 25bp, that would be a sharp departure from their previously aggressive moves, suggesting that the central bank is slowing down.

If a major European bank reveals large losses that may have previously been hidden by lower LIBOR rates, the ECB may be forced to follow in the footsteps of the Bank of England and the Federal Reserve. Another attempt to add liquidity to the markets would indicate that the ECB is concerned about the health of the financial sector, which would make a rate hike out of the question.

Interestingly enough, there are not as many option barriers according to the volatility smile as there was at 1.50. This suggests that extension may not be as sharp. When the Euro broke 1.50 it rallied another 144 additional pips on the very same day and then added 300 pips over the next few weeks with virtually no retracement. Therefore the power of the move above 1.60 will not be as strong as the move above 1.50. In fact, 1.60 could even be a near term top. There is no need to be worried about 1 Euro equaling 2 US dollars anytime soon.

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In the Financial Papers: Today’s Top Forex News 04.21.08

kathysmallHere is the “In the Financial Papers Radio Broadcast” (Length: 6:49 minutes). The player should load automatically. Please let me know if you like it. Contact Kathy

In the Financial Papers:

 

Podcast Covers:
Bank of America Reports 77% Profit Loss and Sells Part of Stake in Chinese Bank
Smaller Banks Begin to Pay Price for Boomtime Expansion
National City Gets $7B Boost from Funds
Bank of England’s Plan for Mortgage Lenders
Australia Reports Sharp Gains in Producer Prices
Reserve Bank of Australia Buys Mortgage Backed Securities
Could the ECB Raise Interest Rates?
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Talk is Cheap for the Euro

The Euro hit an all time high of 1.5983 against the US dollar following better than expected trade balance numbers. The strength faded quickly however when Eurogroup President Junker told the markets that they “did not correctly understand G7 message on FX” and he “does not consider the euro’s rise vs. dollar desirable.” This triggered a 100 pip drop in the EUR/USD in a matter of minutes.

junker Junker jawboned the Euro at a time when Euro traders were looking for a reason to sell, which is why the move happened so quickly. However Junker is not Trichet and Trichet is not Junker. This is not the first time that the EU President has complained about the strength of the Euro.

Back in March, Junker said that the Euro was overvalued and in September he said that the strong currency is starting to be a great concern – at that time, the EUR/USD was trading at 1.38. Therefore if he was worried about the Euro 2000 pips ago, he would most certainly be worried about the Euro now.

Weber Instead, we choose to pay far greater attention to the ECB because they are the ones that have the power to impact the currency and monetary policy. Although ECB member Weber also said that currency volatility is not helpful for growth, in contrast to Junker, he feels that the G7 statement speaks for itself. His comment that the next inflation forecasts by the ECB will reflect recent wage deals indicates that inflation is still very much of a concern. With oil prices above $114 a barrel, their focus on price pressure is justified.

The fact that the Eurozone’s trade deficit turned into a surplus in February is proof that the strong currency is not slowing growth significantly. On a year over year basis, exports grew 13 percent while imports rose 11 percent. As explained by Weber, 80 percent of German exports are invoiced in Euros, so German corporations are not particularly exposed to the effect of currency translations.

Trichet Unless jawboning comes from the President of the ECB, comments from Junker or any Eurozone politician will not be enough to stop the Euro’s rise. German producer prices are due for release tomorrow and I expect them to be hot.

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