Foreign Exchange: August 14
Euro Bulls Happy For now, that is, and possibly for a while longer. The single European currency has moved in line with our short-term bullish view first promoted on July 10. In fact EUR/USD virtually hit our upside target of 1.2500 last week, which now acts as key resistance. Ok, let’s point out our technical and fundamental viewpoints. Technicals: Short term, if the exchange rate drops below 1.2400 we could see 1.2300 and possibly even key support in the 1.2220-1.2250 area. However, we think there is still sufficient upside momentum for a re-test of key resistance at 1.2500, a break of which would see a move to the 1.2700-1.2800 area. At these levels, though, we would expect the dollar to reassert itself, and embark on a major medium-term rally. Fundamentals: Dollar weakness over coming days and weeks could arise as investors digest the deterioration in the US trade deficit to US$58.8bn in June, from US$55.4bn in May. We had been expecting this, as everybody had no doubt, due to rising oil prices. China is again a key culprit with regards to the trade figures, a factor that will increase political pressure on the Chinese authorities to revalue the yuan much more than they have done thus far. The trade deficit will of course weigh on the current account shortfall, throwing up once again the question of its financing. We have long argued that although the deficit is a structural weakness of the US economy, its financing is not a major issue going forward. We simply do not buy the idea of foreign central banks diversifying away from US assets in any meaningful fashion. In any case, this is a long-term phenomenon, and not a huge one-off event. As we said last week, as the US tightening cycle continues, the US yield curve becomes more attractive to foreign investors. This certainly proved to be the case these past few days, when a US 10-year yield close to 4.50% was too good to refuse. Although the yield may yet go higher, despite the end of week easing, a US government backed asset paying somewhere in the region of 4.50% is an attractive proposition in today’s marketplace. Furthermore, the world is becoming richer. The rapid improvement in emerging markets (EM) economic growth, which appears sustainable, is creating a virtuous circle of wealth generation. Solid EM fundamentals - due to political stability, sound monetary and fiscal policy decisions, exchange rate flexibility, increased levels of foreign exchange reserves and more manageable debt profiles – are leading to increased portfolio investment into EM assets, as well as increased levels of foreign direct investment. This in turn is helping to promote economic activity. The wealth generation will lead to a greater amount of savings money looking for an investment destination. While the pensions industry in emerging markets will surely develop rapidly over coming years, with increased local investment in local assets, there will also be larger sums of money looking to be invested in secure assets such as US fixed income. This will keep US long yields low on an historical basis, and underpin the value of the dollar. Let us not forget too the euro part of the equation. Despite an upturn in German industrial production, and hopes of more structural reform following the upcoming election, euroland real GDP is set to grow by no more than 1.5% in 2005, with no vast improvement for 2006. And yet, given a mild uptick in inflation, the ECB is unwilling and unlikely to lower interest rates, thereby keeping the refinancing rate comfortably above growth rates in the major European economies. Sure, there are other parts of Europe where growth and inflation are more pronounced, but the key economic drivers of the region are still struggling. Without the possibility of lowering interest rates, structural reform takes on greater importance. Yet in the case of France at least, this way forward is also fraught with obstacles.
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