Managed FOREX Accounts EUR/USD Outlook 2008 3/3

By: Andre Miller
What the Eurozone Outlook May Be

The performance of the EUR/USD is heavily influenced by economic prospects in the Eurozone. Part of the reason the EUR/USD rose to its all-time high of 1.4968 was while the US Federal Reserve lowered rates by 100bp, the ECB raised its rates by 50bp. It was feared throughout 2007 that the strong euro would adversely impact the Eurozone economy. On the contrary, growth was buoyant, as Germany’s exports increased and boosted its trade surplus. Demand within the Eurozone was resilient and emerging markets spurred growth. Taking a cue from the lessons of 2004, when EUR/USD reached 1.36, Eurozone corporations were able to manage their foreign exchange risk much better in 2007 by increasing local production to minimise the effects of a weak US dollar.

Going forward into 2008, growth is finally starting to slow down. Business confidence in Germany slid to its lowest level in two years amid fears that higher interest, tightening credit, and rising inflation could adversely impact the economy. Both the European Commission and the ECB believe that 2008 growth will be less than initial estimates. The ECB has stopped making public statements about the Eurozone being immune to infection from the US business cycle; recent injections of liquidity into the financial system now prove otherwise.

The last statistics on consumer spending and other indices for 2007 all showed lower numbers than the previous month. If the ECB does not lower interest rates in the following months, there could be a serious economic slowdown for the year.

What the Chances of an ECB Rate Hike Are

The year ended with the ECB President reminding financial markets that the ECB will be unrelenting in its program to control inflation and its effects, and they will not be pressured into following the US and UK interest rate cuts. Because of the ECB’s heavy focus on price stability, the market was alarmed when the bank’s 2 percent inflation target was breached in the second semester of 2007. But since the last ECB rate increase in June, they have not made good on their repeated threats to hike rates further. On the contrary, their actions seem to favour a more liberal monetary policy. When LIBOR (for 3-month Euro and 1-month sterling) rates hit record highs in December and did not come down, the ECB infused $500 billion in liquidity into the banking system. It helped to bring down LIBOR rates, but questions remain as to how long they will stay low. Given these considerations, while a rate increase is possible, it is not really that probable. The prognosis is that rates may be cut first before they are raised again, subject to inflation pressure (such as oil at $100 a barrel). But if inflation remains steady or slows, the ECB is more likely to cut rates.

Summing Up

As in the past year, interest rates will be the main driver of movements in the currency markets. There is the chance of the US economy and the dollar recovering in the second semester, but that will depend on further interest rate cuts by the US Federal Reserve and the European Central Bank. A mere shift in ECB monetary pronouncements from hawkish to more neutral tones may be enough to stimulate US dollar recovery in the second half. There are signs of re-coupling in the global economy but it may take until the second/third quarter before this becomes more manifest. For the short term, traders might want to consider that January is usually a good month for the dollar.

Investment
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