Market Opinion
July 3 2005
Dollar On a Roll -article ID 4237
EUR/USD has broken below the key 1.2000 level, suggesting a further decline towards major support in the 1.1800 area. The latest 25bps hike by the Fed ensures that interest rate differentials between the US and euroland continue to widen, rendering the dollar more attractive. Furthermore, the US economy is in better shape than its European counterpart.
Indeed, US real GDP is likely to grow by more than 3.5% in 2005, with recent data showing healthy activity in both the consumer and manufacturing sectors of the economy. Mr Greenspan himself seemed more upbeat on economic prospects at the latest FOMC meeting, and in fact reiterated that policy was accommodative and that this accommodation can continue to be removed at a measured pace. So US rates have further to rise. Compare this to the situation in Western Europe, where economic growth for the region could well drop below 1.5% this year, and Italy is in recession. Sure, inflation is a little stubborn due to high energy costs, and money growth remains strong, but the pressure for a lowering of the refinancing rate by the ECB is increasing, especially in the absence of any meaningful structural reform.
Readers will know that we have been bearish EUR/USD since above 1.2800 in early May, when we suggested a drop to the 1.1800-1.2000 area. On June 19, we actually said that 1.2000 would act as good support and could see the euro bounce slightly, stressing though that 1.2000 was a key level and in fact a neckline of a major head and shoulders reversal pattern. Well, the break of 1.2000 sets up the move to our lower target of the 1.1800 area, where we would expect the euro to find support. No markets move in a straight line, and 1.1800 could prove to be the neckline now. In any case, medium term, we remain bearish the euro, and would not be concerned by any bounce, viewing it merely as a technical correction from a short-term oversold position. Market Opinion can see EUR/USD trading near 1.0000 in the next two years.
This is not so much because we are overly bullish the dollar, it is due to our extremely bearish opinion of the euro. We think the region is lacking direction in economic and political terms. As a result, we reiterate our view that currencies of the more dynamic emerging market economies stand to benefit considerably against the euro, despite the recent run of good fortune.
Returning to the major currencies, the dollar still looks good against the Japanese yen. Again, the fundamentals of the US economy are shining through. Despite a positive Tankan survey, the BoJ is unlikely to move from its zero interest rate policy anytime soon, thereby ensuring a widening of differentials. This could help take the dollar beyond the key 112.00 area to the all-important 115.00 level.
What about the US trade deficit though, we hear you asking. Well, it has not gone away, that is for sure. However, for the moment, although the last set of inflows data was disappointing, we do not see a major problem of financing the shortfall just yet. In fact, we adhere to this theory of stable disequilibria. This means that despite large global trade imbalances - mainly between the US and China - Asian central banks and oil producing countries will continue to invest their surplus levels of hard currency reserves into US fixed income, maintaining US, and therefore global, demand for their products.
We are fully aware of the long-term risks that this entails, but it is important to listen to what the market is saying. At present, it is clearly focusing on growth and interest rate differentials between global currencies, and looks set to do so for a while longer.
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