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Currency Forecast
EUR/USD Outlook
2006 Q1 Review, 2006 Preview
The first quarter of 2006 has been marked by a significant drop in volatility in the currency market with a move towards more range bound trading. The EUR/USD traded in a 500 pip range, compared to the 850 pip range that we experienced in the first quarter of 2005. The major reason for the drop in volatility has been the convergence of interest rate policies of the two central banks. While the US Federal Reserve continues to charge on forward with incremental interest rate hikes, the European Central bank has finally joined the ball game as the EZ economic recovery builds momentum. Interest rate or yield convergence has also compressed volatility, which
in fact has fallen to record lows in many currency pairs. With both central banks set to continue increasing interest rates for the remainder of the year, the competition of who will keep at it longer will probably be the biggest determining factor of where the EUR/USD is headed. The US dollar and the US economy face many risks that could unfold as early as the next few months, but we will not have a major turn in sentiment until those risks occur. As long as the market continues to revise higher its predictions of when the Fed will cease to tighten, the US dollar will be able to hold onto its upside momentum.
It All Hinges on the Fed
The Federal Reserve raised interest rates by 50 basis points in the first quarter, bringing the Fed funds rate to 4.75 percent. At the last FOMC meeting of the fourth quarter and also the first for the new Federal Reserve Chairman Ben Bernanke, the central bank was surprisingly positive on the US economy. The FOMC felt that the slowdown we saw in the fourth quarter was only temporary and that the rebounded growth in the first quarter should moderate to a more sustainable pace. At a time when the market was predicting 5.00 percent money to be the cap, the hawkish comment that further policy firming may be needed sent some analysts to immediately revise their forecasts for rates to go as high as 6.00 percent. The market, however, was far more sceptical, sending the dollar lower in the first few days of second quarter trading. Yet no matter how you cut it, the question is still when will the Fed stop? Most likely, it will not be in the second quarter but based upon current market expectations, it could be in the third or fourth quarter. When the Fed does eventually pull the plug on rate hikes, they will take away the solitary support for the US dollar. Based upon a study that we did last year, the end of the Fed tightening cycle tends to correlate with a major turn in the dollar. How soon this will happen will depend upon how long the housing market holds up, how much further oil prices rise, and how much longer US consumers will continue to dip into their savings to fund their spending.
HousingA Bubble Ready to Pop
Housing remains the real wildcard. There have been many reports that the housing market is about to tip over, but we have yet to see any clear signs of it doing so. Housing market bulls have been saying that price growth is simply normalising from double digit back to single digit gains, which means that real estate should still provide solid investment returns in the future. However, signs of weakness are emerging. Prices have contracted in key states and inventories are mounting. New home sales have fallen six out of last seven months while pending home sales have fallen four out of the past five months. Nationally, median and average sale prices have remained steady, but when you have some builders offering fire sales such as DR Horton who have been discounting their new homes as well as adding on a lot of free upgrades, you know that trouble is brewing. California based homebuilder William Lyon Homes also said that new home orders in the first quarter fell 26 percent from a year ago. This is not just unique to DR Horton and William Lyon Homes as KB and Pulte Homes are both expected to report double digit declines in new home sales in their next report. With the US savings rate having fallen below zero, indicating that Americans are spending more than they earned, we know that much of that spending has probably been fueled by borrowing. This is a behaviour that cannot be sustained for long, especially as Americans are faced with an escalating cost of living; mortgage rates are on the rise at the same time that energy prices are climbing. Of course, many people have been calling for a burst of the housing market bubble for years now and have been proven wrong repeatedly. Yet the mania is getting more and more dangerous with increasing evidence that the day of reckoning may be right around the corner. When that happens, the Fed will be forced to cut short their tightening, which will have strongly bearish implications for the US dollar.
What about the Rest of the Data?
Not all news is bad news though. The labour market continues to hold up very well with payrolls increasing 211k in the month of March, bringing the unemployment rate down to 4.7 percent. As long as job growth remains plentiful, consumers will probably continue to spend, fueling growth. Tax receipts expected in the month of April and May could also add another boost to spending. Although the manufacturing sector is floundering, the service sector is expanding at a healthy rate. The latest retail sales figures also show that consumers are continuing to spend. This means that no matter how concerned we get about the housing market or the fact that oil prices are less than 30 cents away from their all time highs at the time of this writing, until we see a response by consumers to curb their spending substantially, the impact on growth will remain limited.
IranA Hotspot Worth Watching
The most worrisome geopolitical development is official news out of Iran that they have successfully joined the club of nuclear countries by enriching uranium for the first time. This is in direct defiance of the UN Security Councils calls last month for the country to suspend nuclear research by the end of April. The US responded by calling for strong steps against Iran. With two occupations in Afghanistan and Iraq, the appetite amongst US citisens for yet another conflict is decidedly absent. Should this conflict ignite, the dollar could suffer not only because of the imminent risk, but also because another war would only exacerbate the already burgeoning budget deficit.
ProtectionismNot Good for the Dollar
As if the factors already weighing on the dollar were not enough, the US is exercising more protectionism. We first saw evidence of this trend with the rejection of Chinas CNOOCs bid for Unocal last year and then the rejection of the Dubai Ports Deal earlier this year. The Dubai ports deal prompted the US Senate to create a bill that would force the Treasury Department to notify Congress of all proposed cross border transactions. If passed, this would mark the biggest change to US foreign investment rules in 20 years. Currently, the US is warning China, one of its most important trading partners, that if they do not reduce their trade surplus with the US, they could face more protectionist reactions. At a time when the trade and current account deficits are at record highs, overprotecting the US economy will deter much needed foreign investment to fund the deficit, which helps to prop the dollar. Furthermore, there is also an immigration bill looming that if passed, would reduce the availability of inexpensive labour in the US. Closing the door to inexpensive labour in China, while at the same time closing the door to inexpensive labour coming from south of the border, could cause inflationary conditions in the US. This may force the Federal Reserve to respond with higher rates, which could tip the economy into a recession given the high levels of consumer borrowing.
Nimble Rate Hikes from the ECB
Since December of 2005, the European Central Bank has boosted their lending rate by 50bp through two separate interest rate hikes. This has kept a bid underneath the Euro throughout the first quarter of 2006 and will continue to do so as the ECB works to stabilise the yield spread between the US and the Eurozone. When the Fed finally completes their tightening cycle and the ECB finds itself as the only one of the two central banks to be raising interest rates, the Euro could enjoy a fresh surge of buying momentum. Given the continued recovery in the Eurozone and the improving employment picture, the ECB is predicted to raise interest rates at least once a quarter for the remainder of the year. In fact, the ECB was expected to be even more aggressive, but they have become very sensitive to the value of the Euro given the heavily export dependent nature of the region. Therefore, the central bank made sure the market realised early on that they have no plans on increasing interest rates in May but will instead raise them in June. This announcement came on the heels of the Euro hitting 1.2330 in the beginning of April and goes to prove that if the Euro continues to rise, the ECB will also continue to be more nimble with their rate hikes. This helps us to understand why the ECB is pacing themselves and not being as aggressive as the US, who does not rely as much on exports for growth.
Reserve DiversificationStill a Big Positive
Slowly but surely, reserve diversification continues to benefit the Euro. Last year, we heard a lot of talk about reserve diversification by countries like Russia, South Korea, and India. This year, the United Arab Emirates joined the group by shifting 10 percent of their own reserves from dollars to Euros. Of course, compared to many other countries, the UAE only has a small portfolio of reserves, but with talk of China still looking beyond US Treasuries, the Euro should find itself as one of the primary beneficiaries, even if it simply means that China will stop accumulating US dollar reserves. East Asian countries own two thirds of the worlds US$4 trillion of forex reserves, so their activity is particularly important. China has already been looking beyond the dollar as an investment over the past few months as they assume exposure to more tangible assets such as oil fields or gold.
PoliticsRecurring Sore Point
One recurring wrinkle that has been weighing on the Euro is politics. Last year, we had to contend with the breakdown of the EU Constitution, the stalemate in the German elections, and widespread riots in France following the death of two youths living in the countrys poorest suburbs. This escalated in days of intense violence and in reaction to that, the Euro slid to its year-to-date low of 1.1650. By the end of 2005, things had quieted down, but just when you think the uncertainty has passed, it returns once again. In the first quarter of 2006, French citisens were protesting the governments proposed labour reform law. After weeks of protests, the Prime Minister eventually announced plans to drop the controversial law, but even so, the riots and protests over the past year may have had an impact on the countrys tourism market. With the end of the protests comes another uncertainty in the Italian elections. Ringing a tone of events that have passed, the vote for the new Prime Minister was extremely tight with Romano Prodi announced as the winner by a very small margin. Current Prime Minister Berlusconi has refused to concede defeat, citing big discrepancies with tallying of the votes and demanding a recount. We all know what happened when the same situation occurred in the US a few years ago and later in Germany between Merkel and Schroeder. In both scenarios, the officially declared winner still became the eventual winner. However, we do not know how long it will take before Berlusconi backs off and in the meantime, Prodi does not plan on forming a government until May, prolonging political uncertainty. Even if the Italian election comes to pass soon, in a region that consists of 12 countries, we would not be surprised if political unrest surfaces once again.
Conclusion
In the first quarter of 2006, the EUR/USD shook off its 2005 trending mode and resorted to trading in an albeit wide range. The fact that both the Federal and European Central Bank are expected to raise rates in the second quarter should keep this theme intact. However, once the Fed ends their tightening cycle and if the ECB continues to push forward at that time, we could see a more substantial rally in the EUR/USD. How high the Fed will go is contingent upon how much longer the housing market will hold up and how resilient US consumers can be. Yet even if both remain status quo, the US protectionism measures and rising geopolitical tensions with Iran could still weigh on the US dollar. Over in Europe, growth is increasing at a stable rate, but the European Central Bank finds themselves particularly sensitive to exchange rate fluctuations. They remain hawkish, but if the EUR/USD begins to rise significantly in value once again, they will become more and more nimble with rate hikes. Even though reserve diversification is a long term positive for the Euro, recurring regional political issues frequently resurface to remind the world that it is tough to be a currency that is representative of twelve independent countries.
Technical Outlook
After coming off of a big downtrend in 2005, the EUR/USD spent the first quarter of 2006 trading in a 450 pip range. Taking a look at the weekly charts, we see that the EUR/USD is currently in the midst of forming the right shoulder of a major 2 year head and shoulders pattern. At the same time, it is also forming a symmetrical triangle, which suggests that we are reaching a very important turning point for the currency pair. The presence of higher lows over the past six weeks and a positive MACD indicate that bulls hold a modest lead. ADX is also rising, which suggests that the trend may be picking up momentum. However, since we have yet to reach an apex in the triangle, there could be more consolidation before one of the two key levels is breached. A break of 1.2350, which is slightly above the April 7th high, would open the door for a move back towards 1.35. On the other hand, a break below the triangle support of 1.1890 would pave the way for a move towards the head and shoulders neckline of 1.1750 and then a following break below that does not see support until 1.1615, which is the 38.2% Fibonacci support that dates back from the November 2000 low of 0.8225 to the December 2004 high of 1.3670.
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