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Don't Go Shorting the Euro Just Yet

Friday, 06 August 2010 01:15 PM Current | Bio | Archive

At the end of last week, I said I couldn’t rule out the euro rising to the 1.3126-1.3144-1.3240 zone, and in case that happened, shorting the euro further could become more and more interesting.

Now that the euro has risen to the upper level of that zone, I thought it would be helpful to go back in time and see how the world’s key currencies (the dollar, the euro and the yen) have behaved since the beginning of this decade.

By late January 2002, we had a clear picture that began to emerge. Japan seemed to be pursuing a policy of doing all within its power to keep the yen as weak as possible after it started quantitative easing, or QE, the year before.

Interestingly, QE in Japan, at that time, had led to forthright criticism from China and open complaining from the U.S. Treasury and Congress.

All this took place at the same time that the Fed was continuing to cut rates aggressively in the aftermath of the events of September 2001 and the collapse of the technology, media and telecommunications equity bubble.

Of course, nobody came out or ever said that this was an argument about which currency should become the weakest of the group.

Despite the United States subsequently pointing to its stated “strong-dollar” policy, it rapidly became clear that the dollar was on its way to becoming the weakest of the lot.

In stark contrast, European officials were clearly concerned about the weakness of their currency and were taking active steps to remedy the issue by promoting its increased use as a reserve currency.

Investors and reserve managers reacted to this new environment in a logical manner by selling the dollar and yen and buying the euro along with gold and commodity currencies.

By the start of 2005, the major trends that were to define the decade were well in place — with the dollar having easily won the contest with the yen in the race to the bottom.

However, 2005 proved to be something of a countertrend year as the FOMC continued to “normalize” monetary policy at a rapid rate.

In late August 2005, Hurricane Katrina sparked something of a dollar pullback as investors showed their concerns about the inflationary impact of sustained high energy prices in its wake.

However, comments from numerous Federal Reserve officials through September 2005 — making it clear that they remained concerned about the high levels of core inflation — quelled any concerns that the FOMC would stop hiking the federal-funds rate.

Coming at the same time that oil prices were falling, this proved the ideal combination to spark a further healthy rally from 80.59 to 92.39 in the U.S. Dollar Index.

However, by its December 2005 meeting, the FOMC had started sounding somewhat more sanguine about the inflationary outlook.

As we would observe later, this would prove to be the turning point for the dollar (although not immediately) and would fuel the dollar’s downtrend for the next 2 ½ years.

The downtrend was provided with further ammunition in late 2006 as it became clear that the top of the monetary policy cycle had been reached in August 2007. Meanwhile, the Fed’s aggressive actions from August 2007 onward to curb the fallout from the subprime crisis supercharged both the dollar’s decline. But gold, oil and commodity currencies climbed aggressively.

The picture finally began to change in July 2008, which was two months before financial Armageddon hit.

Harsh reality began to set in for oil prices, after their astonishing 18-month run from the beginning 2007 at $51.81 to $145.78 in the middle of 2008 that had in fact seen crude triple.

The world was finally realizing that an increasing number of major economies could face difficult times during the second half of 2008 and that this, in turn, could lead to a significant decline in the demand for energy as well as for a wide range of commodities.

The easing of inflationary pressures that followed proved to be dollar positive as investors turned from seeking the currencies with the most hawkish central banks to, instead, favoring those with the most growth-oriented monetary-policy stance. These forces only intensified in the last four months of the year as the financial crisis sent investors scrabbling for the safety and security of short-term U.S. government paper.

March 2009 proved to be the next turning point as the introduction of quantitative easing in the United States on March 18 sparked a dramatic rally in a wide range of assets, a rapid pickup in the pace of foreign-exchange reserve growth as well as an exodus from the U.S. dollar that lasted until last November.

When looked at in the context of what had happened during the previous eight years, the period between November 2009 and May of this year was something of an anomaly.

Although it is true that Ben Bernanke began asserting in March that the FOMC’s “emergency” measures were no longer warranted, it is easy enough to see that the events of the first half of the year, including the sharp rally in the dollar, were driven by a general collapse in confidence in the eurozone rather than by shifting expectations over U.S. monetary policy.

That’s why I consider the turnaround in early June was so dramatic.

The easing, even if only temporary, of the tensions in the eurozone coinciding with the publication of an unexpectedly weak nonfarm payroll number saw the currency markets snap back to trading on exactly the type of issues that had driven it through most of the previous decade.

Since then, the price action of the dollar has been entirely consistent with the growing sense that the FOMC will keep monetary-policy settings at accommodative levels for some time to come.

Moreover, since talk of QE emerged in The Wall Street Journal at the start of this week, it is noticeable that not only has the U.S. Dollar Index remained under pressure but also that the price of oil has risen by nearly 5 percent.

So, where does all this leave us in the current environment?

Firstly (and perhaps the most important conclusion we can make), the underlying rules that have effectively driven the currency markets during the past decade still remain firmly in place.

Secondly, this year's first-half eurozone crisis was the only extended period of time since early 2002 when these rules no longer applied.

Thirdly, if true, (and that’s a crucial “if”) it makes identifying the driving forces in the months ahead at little more uncomplicated.

In the absence of any further developments in the eurozone crisis, it seems likely that the driving force for the dollar will be anything that impacts expectations about the direction of monetary policy in the United States.

As such, today’s nonfarm payroll number and the upcoming FOMC meeting are likely to be the central events for the week ahead.

Investors also should keep in mind the recent European bank “stress tests” were blatantly designed as a confidence-building measure rather than a genuine exploration of possible systemic weaknesses.

From my view, I still expect a hot autumn in Europe, but personally, I wouldn’t short the euro yet.

I would have patience until there is more clarity about the “still hidden weaknesses that quickly could turn into booby traps.”

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At the end of last week, I said I couldn t rule out the euro rising to the 1.3126-1.3144-1.3240 zone, and in case that happened, shorting the euro further could become more and more interesting. Now that the euro has risen to the upper level of that zone, I thought it...
Friday, 06 August 2010 01:15 PM
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