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Tuesday April 27, 2004 - 23:32:54 GMT
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Weaker Euro On Rate Outlook

ECB President Trichet showed no sign today of his inclination to cut rates so evident in March in his appearance before the European Union Parliament. But I am inclined to think this is a case of democratic centralism. A majority of ECB Council members are opposed to another rate cut and will not consider one unless the data prove convincing. Trichet however, must parrot the party line on rates until the data provide cover for a/ a renewed debate within the Council on the need for a rate cut and b/ the decisiveness to act assuming the data justify a rate cut. The problem with the ECB and rates is less about the balance of economic risks...surely still skewed to the downside (look at domestic demand in Germany...more like firm and household right)...and more about political pressure (resisting government efforts to cut). With Euro Zone growth running under 2.0% and inflation well under the 2% ceiling, the notion that another rate cut would fuel a wave of inflation or even inflation expectations is sheer nonsense. Sorry but a rise in April IFO does not do it for me. Aside from exports, the German economy is lackluster. It needs a weak euro to meander through labor market rigidities and a constrained fiscal backdrop. France is doing better than Germany for sure, with Italy somewhere in between. But for how long unless German growth accelerates? Okay a rate cut may not boost depressed sentiment in Germany or elsewhere in the Euro zone. But can it hurt? Is there major downside to another rate cut? Is the euro at risk of a disorderly decline? No on all accounts. It is all about a low cost insurance policy. Surely if politicians had not been so vocal for the need for another cut there would have been one for now. Okay so don't hold your breath for an ECB rate cut. However, recognize that the balance of risks is lower and most definitely not higher.

If this were the case for why the euro may be headed for a broad decline ahead it would be half told, and less than compelling. Rather it is the direction of official rates nearly everywhere else that presents the strongest case for a weak euro story gaining traction in coming weeks and months (for those who know my concern about the US external imbalance and the long-term prospect for the dollar, rest assured I believe the dollar will reach new lows within 12 months). Led by the RBA, BoE and RBNZ, global rates are in the process of "normalizing". Ultra accommodative monetary policy is no longer appropriate in most developed economies and increasingly developing economies. The Fed has emerged since early April, helped by strong March payroll and retail sales data is currently on board the rate normalization bandwagon (so it should be with GDP growing around 5% and Fed funds rate at a 45-year low). The discussion is no longer about will the Fed hike this year but June or August or back to back, and 25 or 50 basis points ahead of the election. Sure the Fed could end up going just 25 once ahead of the November US election. But undeniably the direction in US rates is higher and the duration lengthy (of the tightening cycle).

The Bank of England seems poised to hike again in May...the latest MPC member to call for this was Marian Bell late Tuesday. On Monday MPC member Tucker said policy neutrality is likely somewhere above 5%, compared with 4% overnight official rate currently. It is reasonable to look for as many as four more 25 basis point moves in the next year at least.

Even the Swiss National Bank is publicly discussing an exit strategy for its near zero official interest rate (0.11% repo rate). Okay it is not around the corner the way it is for the Fed but the direction is clear. And from near zero moving before inflation arrives is a given...the short end of the curve has priced in over 75 basis points by year end.

In Scandinavia the Riksbank and Norges Bank have likely wrapped up respective easing policies and are confident that the global recovery taking root in America and Asia will not leave the Nordic nations behind.

Rate hikes remain risks in both Australia and New Zealand and one by the RBNZ as early as Thursday (late Wednesday GMT). A rate hike in Australia is expected some time this summer.

Japan is moving out of a near decade of stagnation and deflation, albeit slowly. An exit strategy from ultra accommodative monetary policy may already have begun with the end of currency intervention (none noted on the move to 103.40 in late March). A rate hike in 2004 may not be in the cards, but 2005 will see even Japanese rates begin a process of normalization.

Surely there global recovery driving global rates higher will not leave the Euro Zone behind entirely. But for the immediate future the divergence in official rates is an increasingly compelling reason to look for broad based weakness in the euro and strength in euribor futures.

David Gilmore


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