Monday, February 22, 2010

Euro Exchange Rates to hit 1.3000 vs US Dollar Exchange Rate

Foreign Exchange - Pounds Sterling and Euro Exchange Rate Outlook

The bandwagon is gathering speed, as we expected. Bloomberg reports Barclay’s Wu and UBS’ Yu have each cut their 12-month euro exchange rate forecasts (to 1.40 and 1.30, respectively). Gary Shilling predicts parity, which the euro exchange rates has not seen since 2002. At the core of these forecasts is the idea that the ECB will hang on to its current low rate for longer because so many countries will be falling back into recession due to budget austerity, including Spain and the other PIGS. The US, meanwhile, will be raising rates, even if last Thursday’s discount rate hike was not the bell-ringing.

We agree the euro rate is going to remain weak for a very long time to come, but we disagree with the idea that the ECB will be looking at recession data in some countries. The ECB looks at inflation data, period. There is nothing in the ECB’s past behavior that suggests it would refuse to hike rates if it saw inflation (and inflation expectations) rising to a dangerous level, recession in some members be damned. One size fits all, remember? Of course, recession by its very nature is non-inflationary, so the issue may not arise.

Not to be flippant, but Greece not being able to get data to Eurostat on deadline because its finance ministry is on strike to protest EMU-imposed austerity sums up the situation with stunning simplicity - worse than a SNAFU if something less than a full-blown Crisis.

Back on this side of the Atlantic, the Fed’s discount rate hike had a number of purposes, only one of which was to signal a readiness to raise "real" rates (Fed funds). One purpose was to take the punchbowl away from banks after many not only recorded big profits but also paid themselves 2007-level bonuses. A second purpose was to acknowledge that discount window borrowing had fallen back to minor levels, so the hike is a message to all and sundry that the crisis is over. A third reason, which may be wishful thinking although we hope it is not, is that the Fed wants to dampen commodity speculation. We have no way of knowing whether anyone borrowed 28-day discount window money to speculate in pork bellies and gold - it seems improbable, doesn’t it? - but an overall rise in the cost of borrowing does make managers re-consider risk/reward.

As one analyst put it, the discount rate hike didn’t bring forward a rise in Fed funds by one minute, and this is almost certainly true. The Fed is managing expectations, not engaging in monetary policy. The Fed has always played mind games with the market, and this is just another one. We get a number of Fed officials speaking this week, including Chairman Bernanke on Wednesday and Thursday. The expectation is that he will talk about normalization and decline to say much about monetary policy except that the discount rate move wasn’t it. The one to watch is San Francisco Fed Pres Yellen late today speaking on the economic outlook. She is the most straight-shooting of the bunch and often tells us the right perspective.

As noted above, a big move is almost always followed by a corrective move in the other direction as foreign exchange traders take profit, reconsider the reasons for the original move, and sometimes vote with their feet the other way if they perceive the currency is still oversold and more will be leaving the herd. This is called “fading the trend” and is very risky. We have had two such minor consolidations in recent weeks and they were exceptionally lame.

Bye for Now

Barbara Rockefeller
Foreign Exchange Trading
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