Foreign Exchange Euro Correction
We stress the word correction. Last week, we asked whether the dollar positive news surrounding growth and interest rate differentials was priced in, suggesting that a fall through 1.2080 against the euro would set up declines to 1.2150. Since then, the dollar has fallen to around 1.2120, having hit a low at one stage of 1.2206.
A number of factors were behind the move - which could see the euro rally further towards major resistance in the 1.2350 area. Firstly, the dollar had enjoyed a period of strength over recent weeks, in the run-up to hitting major resistance at 1.1900. Secondly, Mr Trichet gave a clear indication that he may not be far from raising European interest rates. Thirdly, hawkish comments from a number of Fed members highlight that the US central bank is still very concerned about inflationary pressures, and that the current tightening cycle is a long way from over. This latter point caused markets to focus on the negative implications for US growth, something which was given more credence by the non-manufacturing ISM number which fell by more than expected in September to 53.3 from 65.0 the previous month. Worryingly, the prices paid component jumped to 81.4 from 67.1. Non-farm payrolls also dropped by 35,000 in September after a revised increase of 211,000 in August and 277,000 in July.
Ok, a problem for the US economy, and potentially the dollar. But let’s not lose sight of the bigger picture. US data this month, and possibly in November too, is going to be downbeat due the Katrina and Rita effect. However, the US economy was in great shape before the Hurricanes struck, and is likely to benefit too from the reconstruction effort. Indeed, the Institute of Supply Management index rose from 53.6 in August to 59.4 in September, the largest one-month rise since May 1991.
Key, of course, will be the consumer. In the non-manufacturing ISM figure, a drop in consumer confidence was a major factor. However, depending on gasoline prices, which do appear to be cooling, we believe the consumer will return. For now, though, the effect on business from lower domestic demand and higher energy costs will be a reduction in profit margins. That said, judging by the fall in unemployment and the upward pressure on unit labour costs, US corporates in general have been enjoying a healthy run of late. Transitory effects on demand are unlikely to overly derail this trend, and furthermore, the US economy as a whole is still expected to grow by around 3.5% this year. While high energy costs are a clear risk to this assumption, the Fed has made it quite clear that the risks are greater to inflation than growth. We adhere to this view, and therefore expect the Fed to keep tightening at a measured pace to at least 4.50% in 2006. As we said earlier, this will cause longer dated Treasury yields to adjust higher, and in so doing, render them that much more attractive to the global pension fund industry.
Against this backdrop, we feel that the dollar will recover from this current correction. Any break of 1.2350 would cause a reassessment of the situation. But in the meantime, we feel that the short to medium term direction is a re-test and break of the key 1.1900 level, setting up a whole new higher trading range for the dollar.
As for USD/JPY, current greenback weakness could well see the exchange rate move back towards key support in the 111.00 region, a break of which sets up a decline to major trendline support around 108.50. However, as outlined above, we would expect good dollar buying firstly at 111.00, and especially at 108.50, setting up a re-test of and eventual break of recent highs.
The same scenario exists for cable. A short-term bounce, possibly even to the 1.8000-1.8200 region, followed by medium-term declines. As the interest rate differential between US and UK rates narrows further, and in fact, begins to favour the USD at some point in 2006, we see absolutely no reason for holding sterling. Moreover, Mr Brown’s growth assumptions are way off track, again, meaning that taxes will have to be raised to plug the growing budgetary hole, making it even more difficult for the great UK consumer to burst forth again.
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