» ECB - No More Beyond 4%

Written by Boris Schlossberg, Senior Currency Strategist, DailyFX

Last night it only took 70 euro cents to purchase one US dollar as the EURUSD reached a new record high of 1.4260.  As euro continues its relentless march upward against the greenback it is easy to imagine 1.4500 or even 1.5000 as the next big target for the pair.However, while the long term trend in the EURUSD remains up for the time being, this Thursday’s ECB announcement of its interest rate decision could prove to be a serious obstacle to further gains for the pair in the near term.

Consensus forecast call for the ECB to keep rates on hold and although President Jean Claude Trichet is likely to maintain a hawkish posture at the post announcement press conference  there is good reason to believe that the current 4% rate may be the top in current tightening cycle as EZ economic growth shows evidence of peaking. Once the foreign exchange  market begins to adjust to the notion of no additional rate hikes from the Euro-zone the euro rally may come to a grinding halt as traders abandon the idea of capturing further yield gains from the currency.

Eurozone Economy – Problems on the Horizon

Manufacturing Weakens

Although on the surface the economy in the 13–member region appears sound, the latest economic data suggests that EZ growth may be slowing substantially. The latest PMI manufacturing readings, while still signaling expansion recorded their  lowest value in 18 months printing just above the 50 boom/bust line at 53.2. Looking beyond the headlines, the French PMI  component came within whisker of falling into contraction territory as it printed at 50.5. Little wonder then that France has been the, most vociferous opponent of higher euro as its industrial sector is clearly suffering from unfavorable exchange rate differentials.

France’s problems are not unique, however. Higher exchange rates will hurt the other major EZ economies soon enough if they continue to remain at these elevated levels. Germany, which so far has fared better than its neighbor, saw July Factory Orders drop by -7.7% and this sharp decline occurred before the EURUSD crossed the 1.4000 figure. Should EURUSD appreciate further, the EZ export sector which has been the primary engine of growth in the region, would suffer from a serious competitive disadvantage and drag the rest of region’s economy down with it.

Inflation Tame

However, the ECB unlike its US counterpart is mandated with maintaining price stability rather than economic growth and while still susceptible to political pressures, the central bankers from Frankfurt are far more likely to focus on controlling inflation than stimulating output. Nevertheless,  the higher euro has dampened most of the inflationary effects of rising commodities which are traded and priced in US dollars. The latest CPI and PPI reading for the EZ have printed at very modest 1.7% and 1.7% levels respectively well within the central banks own target of 2% growth rate.  With inflation relatively muted the ECB has little reason to raise rates at present, as the higher euro naturally creates tighter monetary conditions and tempers price appreciation.

Banking Sector Remains Vulnerable

Yet perhaps the strongest reason for the ECB to remain stationary has to do with the European banking system. Ironically enough, while the sub-prime debt crisis has its origins in US, most of the negative fallout from the losses on those asset backed securities occurred in Europe.  Several German banks needed to be rescued over  the past several months as their losses on US sub-prime debt rose into the billions. As a result the European interbank market has been functioning very poorly with EZ LIBOR rates (the rates banks charge each other for overnight borrowing) trading more than 60 basis points above the ECB target rate.  

With conditions far from normal, the persistent problems in EZ banking sector are indeed the strongest reason for ECB to remain pat on the rate front. As the lender of last resort, it is the central bank’s duty to provide liquidity in times of stress and if the ECB were to raise short terms rates presently, it would only exacerbate an already precarious situation.     

Euro- Back to Anti-Dollar Status

For the majority of 2006 and the first quarter of 2007 the euro rally was driven by the organic strength of the EZ economy. In Q1 of 2006 as EZ GDP growth exceeded US GDP growth for the first time in years, the currency followed suit boosted by the prospect of  rising interest rates as the ECB continued to tighten monetary policy while the Fed remained stationary.  However this pro-euro GDP growth trend reversed itself in Q2 of 2007 as US data printed at 3.8% while EZ GDP disappointed at 2.5%.  While the “GDP cross” is a longer term indicator with substantial lag in price, it suggests that the best days of the EURUSD rally may be over.

If the ECB does indeed stop at 4%, the EURUSD will no longer trade on future expectations of additional rate increases but rather on its old familiar terms as the anti-dollar. It may indeed rally to 1.45 or possibly even 1.50 but only if US experiences a severe recession that would force the Fed to lower interest rates markedly, If on other hand, US economy stabilizes and continues to outperform the Euro-zone, the dynamic that propelled the EURUSD higher over the past 18 months may begin to reverse as interest rate expectation for the two largest economies of the world begin to change.  This week’s ECB meeting may be the first clear signal that EZ rates will no longer rise and as such could be a important milestone for currency traders to consider.

Source: FXCM

This entry was posted on Tuesday, October 2nd, 2007 at 16:10 and is filed under FXCM, Trading. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.