Currencies | Apr 18 2011
– The rise and rise of the euro has triggered further market optimism
– FXCM suggests the opposite is likely to happen
– Under a more severe scenario we might be about to weakness a near collapse, predicts FXCM
Euro Run May Collapse If The Rate Expectations Continue To Ease
By John Kicklighter, Currency Strategist
Fundamental Forecast for the Euro: Bearish
– Germany raises the warning of a Greece debt restructuring while Rehn says it could spark contagion
– Euro Zone inflation accelerates to a 2.7 percent headline clip, rate expectations still falling back
– EURUSD is reaching overbought levels by many standards; but does that necessitate a reversal?
For the past six weeks, the euro has been more or less unstoppable in its rally. Against the US dollar, that is isn’t necessarily saying much; but this currency shown remarkable progress against nearly all of its major counterparts in that period – denoting an inherent fundamental strength. Where is this strength emanating from? Interest rate expectations. Back on March 3rd, the ECB set off a hawkish surge when it telegraphed a rate hike in the following meeting. However, since that 25 basis point tightening has been folded in, we have seen the pace of hawkish speculation stagger. While the euro’s benchmark rate is still looking at the biggest cumulate advance over the coming 12 months; the intensity of that expected climb has decelerated. If interest rate expectations has been one of the strongest catalysts for the shared currency; what happens when conviction eases? The logical math is easy to calculate. And yet, the euro is still trying to maintain its buoyancy. Can it last?
Delving into the rate debate, we note that there is zero chance of another rate hike at the next ECB meeting according to overnight index swaps from Credit Suisse. That is a reality that was likely already priced in – even if the hearty forecast for a 50bp hike at the last meeting likely denotes there is a large minority expecting something more accelerated. More important is the outlook for the year. Here too, it seems the markets are releasing they were too optimistic. The 12 month rate forecast in less than two weeks dropped from 141 basis points to 99 basis points. That is a pretty dramatic fall back to earth for rate speculation. This pullback is somewhat interesting considering we were presented with a pickup in region-wide CPI (headline accelerated to a 2.7 percent clip and core to 1.3 percent); but then again, these aren’t exactly breakneck levels. More important is the risk on the other side of that policy coin.
If price pressures weren’t in the picture; what would policy officials and market participants focus on? Economic activity in the Euro Zone is dramatically different from one country to the next. The same could be said about the financial stability of the members; but here, the links between the countries means that pain for one will be shared by the others to some extent. This is a reality that many still do not prescribe to. There is a significant portion of the market that believes that a stalwart German economy is unassailable. However, if IFO President Hans-Warner Sinn is right, the ties that robust EU members share with their struggling counterparts could lead to substantial troubles down the line.
Should concern that the troubles in Greece, Portugal and Ireland can lead to much greater financial burden to the rest of the region, the euro’s stunned position after its rate expectations fell back will turn into a genuine reversal. Should the market decide to pay heed, it would draw the focus to the growing debate over the merits of a Greek restructuring, Ireland’s refusal to budge on its corporate tax and Portugal’s struggle to come to bailout requirements with the government in transition. Conditions are discouraging and they worsen with each week that policy officials don’t offer a meaningful fix. If market-wide sentiment were to collapse, the euro would be highly exposed and likely transition from congestion to a sharp correction.
The views expressed are not FNArena's (see our disclaimer).
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