Outlook on the Euro to US Dollar Exchange Rate

Currency Outlook: What Bernanke and Paulson say today to the House Finance Committee will be parsed carefully for clues as to how frightening conditions really are. They will, of course, choose their words carefully. It’s not the right venue for Bernanke to disclose any clues on monetary policy—that comes next week in the semi-annual testimony—but as the Fed seeks new regulatory powers out of necessity, we want to know what the “necessity” looks like. Commentators are pretty sure the Fed is seeking to extend the special auction facilities for investment banks into next year, among other things, which implies such liquidity provision is needed or will be needed. Since Paulson is advising Bernanke on conditions within the market and Paulson has really good inside information, we can’t say Bernanke is the ivory-tower guy who doesn’t really know what’s going on.

Together they are quite a powerful force.

We now have two big reasons not to expect a Fed hike this year—trouble or potential trouble in the financial sector, and the slowdown worsening or at least looking longer-lasting than the usual US slowdown. It doesn’t matter if neither development occurs—it’s enough that the Fed will be staying on hold because they might occur. It looks like inflation as a top priority—as we thought from a Bernanke speech the first week of June—is out the window. From the point of view of the currency market, the Fed staying on indefinite hold is an outright US Dollar-negative.

Trichet may have said the ECB has no bias going forward after its one hike, but that is literally not believable, especially when he complained about second-round effects the very next week. The ECB will almost certainly hike again this year or early next year, widening the differential against the US. We name the section on the benchmark 10-year bond yield “the main event” for the very good reason that the yield spread is the single most reliable forward indicator of the euro to US dollar exchange rate. In the past year it has gotten tangled up in the price of oil, but the price of oil is like gold (and indeed used to be called “black gold”)—cause-and-effect are so intertwined that nobody really knows which causes which.

Other factors that supposedly “determine” exchange rates are taking a distant back seat these days, including the current account. The Fed just released a study showing that the US current account is likely to widen out quite dramatically in the coming years, but it’s no big deal and can be financed quite easily, with no negative effect on the US Dollar. Of course the study assumes oil prices do not get any higher and the dollar doesn’t get much lower, but that’s what economists have to do—hold some conditions constant.

Coincidentally, The Economist published a piece a week or so ago showing the opposite conclusion—that current account deficits do influence exchange rates. Probably the main deduction from these dueling studies is that they are academic; real traders in the real world and real global investors are looking at yield diffs and oil.

We have no idea whether oil will go to $200 before correcting to a decent (survivable) level, like $100, or whether it heads straight for $500. And nobody else knows, either. We continue to believe that restraint on speculation would be a powerful factor, but of course stricter regulation and prohibiting some speculation always faces the risk that the market just moves from the regulated location to the unregulated location (like the UAE/Kuwait).

We imagine Bernanke will be muted and grim today. We also imagine fear will rise to near-panic levels over earnings next week and fresh ratings agency downgrades. This means stocks will fall and when stocks fall, bonds become the safe-haven, depressing yield further. Add a failure-to-correct in oil, and you have a recipe for a falling dollar. Only if Bernanke is upbeat and even hawkish today can we avert this fate.

bye for Now

Barbara Rockefeller