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Sunday June 22, 2008 - 23:50:44 GMT
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A Falling Tide Lowers All Boats

Market Directions Sunday June 22, 2008

A Falling Tide Lowers all Boats

Wherever you look the financial forecasters are pointing down. The economically decoupled world, where United States grows and slows alone has vanished, replaced by a vision of Atlantic unity. The current crop of long term economic projections all predict sub 2.0% GDP growth in the European Monetary Union and the United States through the end of 2008. If every boat is sinking does it really matter which one you are riding?

In the twelve months since May 2007, statistics in the United States and Eurozone have traced similar paths. In the European Monetary Union (EMU) the Purchasing Mangers Index (PMI) of manufacturing has fallen 9.0%; the service side has dropped 11.7%. In the US the Institute for Supply Management Index (ISM) has slid 9.8%, with the service sector off 10.2%. In the EMU consumer sentiment registered -15 this May, a year prior it was -1. The American Conference Board Survey of Consumer Sentiment recorded 57.2 in May; twelve months earlier it had been 108.5.

Headline consumer inflation, including food and energy prices, has, surprisingly enough, risen faster in the Eurozone than in the United States. In May of 2007 CPI was 1.9% in the EMU; in the US it was 2.7%. A year later EMU inflation was 3.6%; a jump of 1.7%, in the US the increase was only 1.5% to 4.2%. Given the relative sensitivity of the respective banks, 3.6% inflation is probably far more threatening to the ECB than 4.2% is to the Fed.

Likewise, the difference in economic growth between the EMU and the States has been minimal. Despite the central place of the sub prime mortgage crisis in the popular view of the US economy, European and US GDP growth were almost identical in 2007. US GDP expanded 2.48%, the Eurozone 2.65%, a difference of just 0.17%.

The greatest divergence between the world's two largest economic areas now lies in the projections for economic growth in 2008 and 2009. Let's look at the projections of the central banks themselves first. The ECB’s latest estimate posits a range of 1.5% - 2.1% GDP expansion in  2008 and a considerably weaker 2009, with GDP growing only 1.0% -2.0%. The Fed is less sanguine for 2008, expecting only 0.3% -1.2% in growth but more positive about 2009, supposing a GDP increase of 2.0% -2.8%.

The Organization for Economic Cooperation and Development (OECD) and the International Monetary Fund (IMF) have published roughly similar forecasts for the EMU. However, both organizations are far more pessimistic for the United States' prospects.

The IMF suggests the Eurozone will grow 1.4% in 2008 and 1.2% in 2009. This mirrors the ECB’s own expectations for substantially lower growth in 2009 than this year. The OECD anticipates 1.7% in 2008 and 1.4% in 2009.

Keeping in mind the Fed’s GDP projections for the next two years (2008 0.3% - 1.2%, 2009 2.0% - 2.8%) only the OECD estimate for 2008, 1.2%, coincides with the American central bank. For 2009 the OECD predicts just 1.1% growth, barely half the Fed prediction. The IMF is even less hopeful, expecting only 0.5% growth in 2008 and 0.6% in 2009.

Traders have punished the dollar for the past year for two main reasons. First and foremost, because the Fed has cut rates by 3.25% while the ECB has been on hold. But running a close second has been the concern and fear engendered by what the mortgage and credit crisis would do to the US economy.

The Fed has ceased cutting rates and without a further serious collapse in the US economy it will probably sit tight until the economy begins to recover. The economy itself has not, so far, fallen into the catastrophe that began to be predicted almost immediately upon the advent of the credit crisis last summer.

The ECB on the other hand has made it very clear that the Eurozone economy may have to fall into recession before it will relax its grip on inflation.

Two major factors, one known and one unknown could affect the US outlook for the remainder of the year. The known factor is money supply. With the Fed priming the money pump, traders can reasonably expect an economic response in increased growth sometime in later 2008 or early 2009. The unknown is the American consumer. Despite all of the economic concerns, the housing market collapse, slowly rising unemployment and historic gasoline prices consumer spending has, so far, been another long predicted catastrophe that has not happened.

The ECB has all but promised to raise rates in July. But they have also given their word that this will be the only time. Ben Bernanke has threatened renewed attention to inflation and underlined the role of weak dollar in exploding commodity prices but almost no one believe the Fed can raise rates on the weak US economy. Even if the ECB raises rates in July, a one time hike will not cause the euro to prosper. It is rate cycles that push long term trends in currency markets and neither central bank in a position to begin the opposite cycle: the Fed cannot raise and the ECB cannot cut.

After the prospective July ECB hike, the two central banks will be in an extended period of vigilant watchfulness. The Fed has simply stated that rates are more or less where they need to be. ECB spokesmen have gone out of their way to assure the market no hikes are planned after July. If the ECB is not going to hike in the face of rising inflation they are certainly not going to cut. And conversely if the Fed is not going to cut in the face of economic weakness they are certainly not going to hike. Neither bank is in the position to do much of anything for the rest of the year except talk.

Likewise the competing economic zones of the US and the EMU will probably provide little to choose between them for the next several months. The US is currently growing much slower but it has a substantial economic stimulus already working and owns a continent of spend happy consumers. The Eurozone is laboring under restrictive monetary policy and harbors a continent of worriers. The result is going to be a US economy supported by a worried Fed and optimistic consumers, while the EMU is dragged down by a stingy central bank and pessimistic consumers.

Currency traders watching for the next trend in the euro and the dollar will have to be patient. Range trading will continue to frustrate both dollar shorts and dollar longs for several months yet.

Joseph Trevisani
FX Solutions
Chief Market Analyst

[email protected]


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