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Sunday June 8, 2008 - 21:50:30 GMT
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Chaos Theory

Jean Claude Trichet, President of the European Central Bank (ECB) has to be a bit surprised at some of his handiwork. The collapse in the dollar and the Dow and the record rise in crude oil were not all his doing. Serious supply concerns, Israeli threats, Asian demand and a violent short squeeze helped drive the oil market to record levels. Non Farm Payrolls and particularly the unemployment rate, which jumped 0.5% to 5.5% in May and renewed financial sector worries, slammed American stocks.

But it was Mr. Trichet’s comment that the ECB “could decide to move rates for a small amount in our next meeting” that cut the legs out from under the dollar and started the huge spike in oil prices. No one in the markets expected such a move by the ECB. When the value of dollar declines the cost of crude oil, priced in dollars, rises. For the American consumer, the price of crude oil has a direct translation into consumer spending. A sustained contraction in consumer spending will surely push a fragile US economy into recession. The American economy has a new and immediate threat as oil now seems poised to race to $150.

Mr. Trichet has long had a policy of informing the markets of the internal discussion of the central bank governing board. In letting the market know that a rate increase was advocated by several board members and could happen in July he was simply continuing that policy. His comment was then reinforced by Axel Weber, president of the German Central Bank and ECB board member when he said that the market “seems to have well understood” the “strong signal” that the current inflation situation is not “acceptable”. Indeed it did, but at what cost?

Mr. Trichet has often and publicly called for US officials to support the dollar. Ben Bernanke, the Chairman of the Federal Reserve, finally did so early in the week and it was one of the reasons the dollar had reached its highest point against the euro in more than a month on Thursday. But any positive effect on the dollar from the Fed Chairman’s comments was swamped by the adamancy of the ECB.

The ECB is rightly concerned about inflation with the latest harmonized inflation reading 3.6% in May almost double the bank's target of 2.0%.

But oil and energy prices are one of the main drivers of European and worldwide inflation. The price of crude had fallen to below $122.00. On Friday it closed at $138.54. The dollar lost 2.6% against the euro on Thursday and Friday; the price of oil rose more than 8.4% on Friday alone. The Thursday and Friday rise in oil on the New York Mercantile Exchange was a record for the exchange.

The ECB has damaged its own case against inflation. What will generate higher inflationary expectations more than a sharp hike in gasoline prices? Would not a sustained 15% or 20 % drop in the price of oil do more to counter inflation in Europe than threatening to push a rate increase on a slipping European economy? Will not higher energy prices further undermine European GDP and fracture consumer spending?

The European consumer should be the beneficiary of a strong euro with increased purchasing power for foreign goods. But retails sales in Europe fell unexpectedly 0.6% in April, the fifth fall in the six months to April. European consumers have historically underperformed their American counterparts. It seems clear that the European consumer is more attentive to historical precedent, more attune to pessimism than optimism. Exactly the opposite of the US consumer.

The US economy is weak, payrolls have fallen for five straight months, but it is not yet recessionary. The total job losses since January are about what were recorded in one month during the 2001 recession. The unemployment rate rise to 5.5% was likely a product of an unprecedented number of young workers reaching the job market in May and skewing the seasonal adjustment to the unemployment rate. (You can easily see parents of vacationing college students saying, the economy is weak get out there early and find a job). A portion of the 0.5% increase will probably return in June. Without this group the unemployment rate in May would probably have been 5.2% or 5.3%.

But the American economy can ill afford the hit to consumer spending that will follow a crude oil price of $150 a barrel. The lower the dollar falls the higher the price of oil climbs. The ECB may have started an avalanche that will bury their inflation worries in a recession.

Joseph Trevisani
FX Solutions
Chief Market Analyst

[email protected]


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