Trouble Brewing in Europe Could Send EUR/USD to 2 Yr Low

The big story in the currency market today is the Euro which hit a 2 month low against the US dollar. Ratings agency Moody’s warned that the exposure of Western European banks to Eastern European loans could affect their credit ratings. Up until the global credit crisis, Eastern European nations were growing at very rapid rates. This enticed many Western European banks to lend as much as $1.7 trillion to those nations. According to Morgan Stanley’s Stephen Jen, $400bn of that debt is expected to be rolled over this year – about a third of the region’s GDP.

On top of that, many companies in Eastern Europe were sold foreign exchange contracts to protect them against appreciation in their currency. Poland’s Polsi Koncern Meisny Duda SA (a meatpacker) reported that their currency derivatives contracts have floating losses of 29.3 million Zloty ($7.8 million). They wanted to hedge against a higher currency but instead, the zloty plunged 33 percent. Similar problems are expected for other Eastern European corporations. This could be a domino effect that hits the region as a whole.

Within the Eurozone, there is still fear that Ireland could default on their debt as credit default swaps hit record highs. A default in Ireland will add tremendous pressure on the Euro.

All of these problems brewing in Europe will mean more losses for European banks. This could force the European Central Bank to take more aggressive action on a monetary basis and drive the EUR/USD down to its 2 year low of 1.2330.

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Why EUR/GBP Could Hit Parity

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What is Trichet Thinking?

Here is a snippet of my comments about this morning’s price action on FX360.com:

There has been a lot of action in the currency market this morning, mostly centered on the British pound and Euro.

ECB President Trichet is not buckling under pressure. After leaving interest rates unchanged at 2.00 percent, he refused to make any decisive comments on where interest rates are headed in March. Trichet is still buying time to see how the economy and price pressures respond to their recent rate cuts. The Euro has held steady because Trichet said he is not pre-committing or excluding anything. The zero interest rates that Prof Roubini is calling for is out of the question especially for a central bank that remains obsessed with inflationary pressures. Trichet acknowledged that inflation will continue to fall but he expects it pick up in the second half of the year and if oil prices rebound, the acceleration of price pressures could exacerbate. Rather than being completely downbeat about growth, Trichet said that even though the risks are clearly to the downside, there are signs of stabilization. By postponing rate cuts, Trichet is putting his credibility and reputation on the line.

The ECB cannot stop cutting interest rates at this time especially as we continue to see very weak economic data. German factory orders fell 6.9 percent in the month of December, more than double the market’s forecast. Trichet who is known for his candor has already admitted that 2 percent will not be the lowest level for Eurozone interest rates and the market may be right to bet on a 50bp rate cut in March. If he doesn’t plan to cut interest rates to 1.5 percent next month, he would not comment on the market’s expectations. Although zero interest rates is off the table, we do not think that the ECB will stop at 1.50 percent. Interest rates could fall as low as 1 percent, which is why we could see more weakness in the Euro.

EUR/GBP Crushed After BoE Rate Decision

EUR/GBP collapsed following the Bank of England’s decision to cut interest rates to 1 percent. Even though the yield advantage in EUR/GBP has increased from 50bp to 100bp in the Euro’s favor, the market is less focused on interest rate differentials and more focused on recovery. The pound is trading higher because the Bank of England and the UK are being rewarded for their aggressive monetary and fiscal stimulus. The Euro on the other hand is being punished for implementing sluggish monetary policy.

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How the Strong Euro Changes Things

The EUR/USD has reversed violently after hitting a high of 1.4719 today. I don’t think that it is a coincidence the currency’s rally stopped right at the 200-day SMA.

If you caught my Daily Currency Focus yesterday on GFTForex.com, I wrote about the consequences of a strong euro. I think its important for everyone to give this a read:

The Euro’s recent rally is a testament to the impact of interest rates on currencies. We have long said that this is the number one driver of currency trends and the decline in liquidity near the end of the year has only exacerbated the rally.

Although the latest move in the Euro has some bank analysts revising up their EUR/USD 2009 forecasts to 1.60 and above, we want everyone to realize that the higher the EUR/USD rises, the more strain it will put on the Eurozone economy and the more reason it gives to the European Central Bank to cut interest rates. When the ECB first started to talk about pausing in January, the EUR/USD was trading around 1.26 and it has now appreciated 14 percent. Even though we also believe that the EUR/USD will continue to rise, we think that it may have a difficult time cracking above 1.48 and eventually, the trend will change. France’s largest bank BNP Paribas has been hit hard by the Madoff scandal. This is an example of the troubles plaguing European corporations. Consumer prices declined 0.5 percent last month, giving the central bank plenty of flexibility to cut interest rates if necessary.

Update today: The fact that the German IFO business confidence report also hit the lowest level since 1982 only confirms my belief. According to Barclays, the 11% rally in the trade weighted Euro is akin to a tightening of 175bp!

Watch out for a shift in ECB rhetoric. I still think that the US dollar is headed lower in 2009, but that does not preclude a retracement in the Euro that is driven by a surprisingly abrupt shift by the ECB’s stance on their January rate cut stance.
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Euro: Headed for 1.35?

Hawkish comments from ECB member Weber is driving the EUR/USD through the roof. The currency pair is up close to 2.5 percent or more than 300 pips.

After cutting interest rates by 75bp earlier this month, ECB member Weber said today that a January rate cut is not a done deal. He pointed out that the ECB has never taken interest rates below 2 percent and that the central bank doesn’t have enough info to decide on a January rate cut. Market tensions are expected to ease next year and he really wants to avoid negative real interest rates. More importantly, he added that when the economy recovers, the ECB will need to raise rates promptly.

In terms of monetary easing, the ECB has been one of the least aggressive central banks this year. They have only cut interest rates by 150bp, compared to the 325bp by the BoE. This is why EUR/GBP is moving closer to my 0.90 target.

With the Fed cutting interest rates next week, the hawkish comments from the ECB will fuel further gains in the EUR/USD going into the US rate decision – there is nothing standing in the way of EUR/USD hitting 1.35.

ECB Disappoints with 50bp Cut, Trichet’s Comments

It is the morning for rate cuts with the European Central Bank, Bank of England and the Swiss National Bank all cutting interest rates. On a day when the Bank of England shocked the markets with a 150bp rate cut, the ECB and the SNB’s half point cut seemed very small in comparison.

Every major central bank is worried about growth but not as worried as the ECB. Unlike King who openly admitted that the economy is in a recession, when asked the same question, Trichet simply said “we will see.” On future rate cuts, he said that the ECB never pre-commits . If Trichet was serious about cutting interest rates aggressively, he would not be qualifying his comments on inflation and future rate cuts.

trichet In his post meeting press conference, ECB President Trichet was not as bearish as he could have been given the sharp deterioration in growth.

He spent the majority of his time discussing inflation and how it is set to ease but skirted over growth and the economic outlook. Larger rate cuts was discussed but the decision to cut by 50bp to 3.25% was unanimous. Compared to the BoE, the ECB’s tone is less dovish.

The ECB is a much more conservative central bank and it is clear that their monetary policies are more restrictive. They have only cut rates by 75bp this year when taking into account their rate hike in July.

More rate cuts will come from the ECB, but Trichet’s comment about not pre-committing to rate cuts indicates that they will not be making rate cuts in excess of 100bp like the BoE. Trichet feels that he has already done a lot by cutting interest rates twice in 1 month.

The sharp divergence in the actions taken by the ECB and the BoE today should help the Euro recover against the British pound.

Source: eSignal

Source: eSignal


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