The EUR/USD ripped higher after ECB President Trichet telegraphed a possible rate hike next month. The rise in oil prices has hit a cord with the central bank, prompting them to step on the accelerator and get moving with curbing inflation pressures. Not only did Trichet use the magic words “strong vigilance,” but to remove any uncertainty, he said point blank that “Vigilance means rates may rise next month , increasing rates in April meeting possible.”
Regardless of how much Trichet tried to tone down this comment later on by saying it is not appropriate to expect a “big rate move,” and they are not ready to embark on a “series of rate hikes,” the mere prospect of a rate hike is very positive for the euro. Even if the EUR/USD does not take out 1.40 today, it should just be a matter of time before it does so. Based upon Fed Chairman Ben Bernanke’s comments earlier this week, the U.S. central bank is still straddling the fence in terms of normalizing monetary policy. In contrast, the ECB has sent a very clear signal to the market that rates will increased over the next 1 to 2 months. This dynamic should cause the dollar to continue to underperform against the euro.
The race is now between the ECB and BoE and the way its looking, the ECB could be the next central bank to raise interest rates. The central bank upgraded its inflation forecast for 2011 to 2.0 – 2.6% from 1.3-2.3% forecast in Dec and their 2011 GDP forecast to 1.3-2.1% vs. 0.7-2.1%.
It has been a very volatile week for the US dollar, even though compared to the beginning of the week, the exchange rate for the EUR/USD and USD/JPY has remained virtually unchanged.
On Monday, the EUR/USD was trading at 1.5922 while USD/JPY was trading at 106.26, not far from current levels, but of course these rates masks what can only be likened to a rollercoaster ride in the financial markets. There was a number of event risks and economic data released over the past week, yet the drivers of the financial market volatility can be boiled down to 2 things; the health of the financial sector and oil prices.
We have come a long way since traders first speculated about the possible demise of Fannie Mae and Freddie Mac. The Federal Reserve and the Treasury have offered different solutions to avert more serious problems while Freddie Mac has announced plans to raise capital by selling as much as $10 billion in new shares to investors. Based upon the 600 point recovery in the Dow off of Tuesday’s intraday low, for the time being traders believe that this could be enough.
JPMorgan and Citigroup have reported better than expected earnings even though Merrill Lynch disappointed; 2 out of 3 appears to keep the markets happy for the time being. As for economic data, we learned that inflation remains hot but consumer spending is beginning to falter.
With the US economic calendar considerably lighter next week, the health of the financial sector, oil and the stock market will continue to set the tone for the FX markets. Earnings season is in full swing. Bank of America will be releasing their earnings report on Monday and for the rest of the week there will be a number of regional banks reporting. Leading indicators, durable goods, the final July UMich consumer confidence numbers, new and existing home sales are due for release along with the Federal Reserve’s Beige Book report. We will be keeping a particular close eye on the Beige Book report because it will serve as a temperature gage for how the US economy is really doing and how businesses and consumers may coping with the latest developments in the stock and commodity markets.
Eurozone Economy Continues to Slow
The Euro is consolidating near its all time highs against the US dollar, even though we are reminded on a near daily basis about the risks to Eurozone growth. Last night I was having dinner with a businessman from France and he described to me the sour mood in Europe. He indicated that businesses are growing very pessimistic which confirms that Europeans are tightening their belts as they learn to deal with high prices. This conversation comes at a perfect time because the marquee release on the Eurozone calendar next week is the German IFO report of business confidence. Like the ZEW survey of analyst confidence, business confidence should have deteriorated materially over the past month. Not only did the European Central Bank raise interest rates for the first time since June 2007, but exports, factory orders and industrial production have also plummeted which confirms that business activity has dropped significantly.
The Euro is rallying ahead of Thursday’s ECB monetary policy meeting telling us that the market expects ECB President Trichet to say something hawkish. A 25bp rate hike has already been discounted by currency traders, but with the annualized pace of Eurozone producer prices growing by the fastest pace on record, consumer spending in Germany doubling expectations and the German unemployment rate falling to a 14 year low, the ECB may have to reconsider their plans to raise interest rates by only 25bp this year.
The ECB is a central bank that hates surprises and because of that, they always like to prepare the markets weeks if not months in advance of any pending move. That is why they have been telling us that a 25bp rate hike, which wouold be their since 2007 is the appropriate expectation for the upcoming monetary policy meeting. They have also been warning that they are not planning a series of rate hikes. However the ECB may have to backtrack on these words given the recent economic reports.
There are 3 possible scenarios for the upcoming interest rate decision that my Currency Analyst Terri Belkas outlined at DailyFX.com.
The most likely is scenario 2 where Trichet hikes by 25 and then signals that additional rate hikes could come. But I would not completely rule out the possibility of a 50bp rate hike.
Scenario 1: +25bps to 4.25%, Trichet Suggest It’s A One-And-Done Deal
While the EUR/USD is likely to jump on the 7:45 EDT announcement of a 25 basis point rate hike to 4.25 percent, any sort of rally will immediately reverse if Mr. Trichet suggests in his post-meeting press conference at 8:30 EDT that the bank has no intention of increasing rates further. This is the most probable scenario, and traders should watch for comments that indicate that downside risks to growth may help to offset upside inflation risks, or notes that “the current monetary policy stance will contribute to achieving our objective” of price stability.
Scenario 2: +25bps to 4.25%, Trichet Signals Additional Hikes
After hitting a record low against the Euro on Tuesday, there has been little follow through selling in the US dollar, leaving many traders wondering whether this may be a pause before further losses or a potential bottom.
Although I am a long term dollar bear, the break of 1.60 is far from impressive. This indicates that there isn’t much speculative interest in taking the Euro higher in the near term, especially as economic data and official comments start to turn against the Euro and in favor of the US dollar.
Earlier this week we had better than expected US housing market numbers. I would not be surprised to also see a recovery in new home sales. Even though US durable goods will be pressured by the sales of furniture and electronics, Boeing’s incredibly solid end of quarter earnings and their expectations of another strong year suggests that sales of non-defense aircraft could be firm.
As for the Eurozone, we expect German business confidence to deteriorate materially.
Fed fund futures are currently pricing in an 82 percent chance of a quarter point rate cut next week with the remaining 18 percent probability in favor of no rate cut at all. This is a sharp departure from just a week ago when the market was pricing in a 76 percent chance of a 25bp cut and a 24 percent chance of a 50bp cut. The only reason for this dramatic shift in expectations is the increased inflationary pressures.
A week ago, oil prices were trading at $113 a barrel and yesterday it hit an intraday high of $119.90 a barrel.
The dollar should continue to recover for the rest of the week, but the party may end the following week when we have the Federal Reserve interest rate decision and non-farm payrolls due for release. I believe that the market may be under pricing the degree of Fed rate cuts because the problems in the US economy are far from over. Non-farm payrolls should continue to drop while consumer spending will probably slow, leaving the Federal Reserve with a lot of work ahead of them.
One of the strategies in my High Probability Trading eBook is called the Extension Fade. The strategy looks to fade a move after a currency pair has rallied or fallen for a certain number of consecutive days.
According to the eSignal chart below, EUR/JPY is now on its EIGHTH consecutive day of strength. In the past 10 years, there has only been 6 times that EUR/JPY has rallied for 8 days in a row! This move has statistical significance and for that reason, there is a strong chance that the currency pair will top out very soon.
Fundamentally, there are also reason to believe that Euro selling will also continue. This morning we had weak German PMI numbers and tomorrow we are expecting the German IFO survey. A little watched index called the Belgium Business Confidence Index tends to have a strong correlation with the German IFO index as indicated by the chart below. In the month of April, the index fell to a 2.5 year low. This suggests that German business confidence could drop as well, which would be the fundamental catalyst needed for a more meaningful turn in the Euro.