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Wednesday August 27, 2008 - 19:36:22 GMT
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Forex Blog - Market In Front of ECB on Easing Expectations

We are used to Fed officials using the power of verbal intervention to reshape market expectations between FOMC meetings, though more often than not via surrogates in the financial press like Ip, Reddy and Guha.  What is less obvious is when the ECB engages in expectations management between monthly governing council meetings.  Indeed it is less obvious because it is so obvious that markets often ignore the message.  Well in the last 24 hours ECB’s Stark. Weber and Bini Smaghi all seemed to be singing from the same hymn sheet…hey markets we are not in the lest bit considering rate cuts ahead (markets are priced for Q1) and furthermore we may have to hike more…second round price effects are materializing (from rise in commodity prices).  And growth naysayers in the Euro Zone be damned…the ECB is not nearly as pessimistic on growth as the market.

EZ rates and the currency responded accordingly to the shotgun warning from the ECB.  These are not rogue ECB council members like the Fed’s Fisher riffing on a song he can’t get off his mind. 

No this is no call to return to the recent days of long euro/dollar – I conceded that one two weeks ago and in the height of the position liquidation.

However.  I am skeptical that the steepest rally in the dollar arguably since the Plaza Accord in 1985 has Plaza Accord-like legs.  Yes the world needed to come to terms with weakening growth in the rest of the world ex-US.  It has done that.  It is now the time to ask can the dollar run to 1.40 on this US economy and that weakening ROW economy?  I just can’t buy into it.  A more logical response is that the bear cycle for the dollar was broken, but a bull cycle was not born…range trading is my best guess ahead and not ever higher highs for the dollar. 

Moreover the borrowing requirements of the US public and private sector are expected to soar ahead demanding more foreign capital.  And with the dollar rally to date US exports have lost something of an edge on competitiveness compared to just a few weeks ago (yes FX impacts exports with long lags, but it impact corporate earnings immediately). 

And if the US needs ever more foreign savings to cover current investment and consumption then US rates have to rise – very likely market rates as they have for private-sector debt and in time as they will for public debt.  This will put more stress on credit and economic growth, even if it helps stabilize the dollar. 

I have heard the argument made that interest rate futures are pricing in 75bps of Fed tightening 12 months out and 75bps of ECB easing 12 months out and this will drive the dollar to 1.40 versus the euro.  But since when are 12-month official interest rate expectations an accurate predictor of future official rates in 12 months?  Rarely. 

If you like dollars then you have to be counting on lower oil prices (lower commodity prices) which will be driven by demand destruction.  How does the US economy hold up in a global slowdown with a broken banking system, falling home prices, elevated consumer indebtedness and declining corporate earnings.  So I am of the view that in time the correlation between the dollar and oil will break down.

My range for euro/dlr?  1.45-1.50 seems reasonable through Q4.

David Gilmore


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