August 7 2005 Foreign Exchange Euro Off The Ropes
As we have been saying for the past few weeks, the euro is showing upside potential against the dollar. The break above 1.2250 sets up further gains towards 1.2500, with the possibility of a re-test of the important 1.2800 level over the coming weeks. 1.2250 now acts as support on any retracement. Our reasoning behind a euro bounce was two-fold. Firstly, we viewed the 1.1800-1.2000 as major support for EUR/USD. Secondly, the positive US economic data appeared to be very much in the price, as the dollar started to show signs of exhaustion at these higher levels. Indeed, even a strong US non-farm payroll number, which shows clear signs of improvement in the US labour market, had little upside impact on the dollar. Instead, last week’s rally in the euro coincided with a noticeable improvement in German industrial production numbers, with the market preferring to pick up on any signs of an economic revival in euroland. In addition, the US current account deficit could well return to the haunt the dollar. Stronger growth, coupled with high oil prices is likely to put upward pressure on imports. This together, with ongoing talk of foreign central bank reserve diversification will weigh on sentiment. Indeed, we see further dollar weakness as US Treasury yields continue to rise. However, the market should not forget the problems of euroland. The Market Opinion jury is still out as to whether any recovery is sustainable. In fact, real GDP will grow by 1.5% this year at best. Last week we pointed to the German elections in September as a key determinant of euroland economic activity going forward, insofar as a CDU/CSU majority would vastly improve the chances of structural reform, so badly needed to promote long-term growth in the region. Latest surveys, though, show an erosion of the previous CDU/CSU majority, increasing the likelihood of a grand coalition, which would spell bad news for the reform process. As such, despite some encouraging signs of late, our medium-term concerns for economic growth and political direction in euroland remain. This makes it hard for us to believe in a sustainable euro bounce beyond the key 1.2800 level. Moreover, much of the improvement in German manufacturing has been due to the weaker currency. Any significant appreciation would put the sector back in trouble. Furthermore, despite ongoing fears over the financing of the current account deficit - which is entirely natural given its size – tighter monetary policy by the Fed will render the US yield curve increasingly attractive to foreign investors. Although we see higher US Treasury yields over the coming weeks, we do not think foreign investors are going to cease purchasing US assets. At some point, yields on US government paper will be too good to refuse. This could well coincide with a rebound in the dollar. For the moment, though, US Treasury yields are rising, as is the euro.
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