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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