Can Europe Handle 1.40 Euro?

DailyFX Fundamentals 09-20-07

By Kathy Lien, Chief Strategist of DailyFX.com

Euro Hits Record High

It has been an extremely active day in the currency markets with the US dollar falling to record lows against the euro and 30 year lows against the Canadian dollar.

For months, the currency market has been obsessed with 1.40 in the euro and 1.0 in USD/CAD. Now that these targets have been achieved, the question ahead of us is how much further can the euro rise.

In the currency markets, trends can last far longer than most traders expect and even though the risk of a top increases with each pip rise, there is no reason to believe that the EUR/USD will top out until the currency pair itself manifests weakness.

Fundamentally, the US dollar has been driven to a record low because of growing concerns about the US economy and the possibility of further interest rate cuts by the Federal Reserve. Although speculation of Saudi Arabia abandoning its dollar peg triggered the break of 1.40, the country's later denial of this possibility did not lead to similar relief rally in the US dollar.

Therefore this tells us that there is a lot more than speculation driving the dollar's weakness. We have often said that the expectation of where interest rates are headed is the number one driver of currency movements.

The latest bout of dollar weakness is a reflection of not only the larger rate cut delivered by the Federal Reserve earlier this week, but also the expectation of anywhere between 25bp to 50bp of further easing before the end of the year. Yet, the further the dollar falls, the greater the risk of a reversal.

A weakening currency will not only help to boost exports and revive the economy, but it will also induce inflationary pressures. So the question in front of us is what will get out of hand first, growth or inflation. All it takes for the euro to stop rising is a few pieces of stronger US economic data or any concern about euro strength by European Central Bank (ECB) President Jean-Claude Trichet.

Unfortunately we have yet to see a meaningful improvement in US data. Even though the Philly Fed index jumped from 0 to 10.9, it was offset by a larger than expected drop in leading indicators. Fed Chairman Ben Bernanke made no direct comments about the state of the economy or monetary policy.

He simply said that the rate cut was taken to stay ahead of the credit markets.

Meanwhile gold prices hit 28 year highs while oil prices hit a new record high of $83 a barrel.

Canadian Dollar Now Even With US Dollar Thanks to $83 Oil

At the beginning of the year, many people did not believe the Canadian dollar (CAD) could hit parity with the US dollar, but for the first time in over 30 years, $1 is worth CAD$1.

Although USD/CAD has rebounded since hitting an intraday low of 0.9993, the possibility of solid retail sales tomorrow could be all it takes to bring the currency pair back below parity. Canadian wholesale sales were released today and in the past, we have found wholesale sales to be an incredibly accurate leading indicator of retail sales.

Therefore the 2.0 per cent rise in wholesale sales suggests that we could see a sharp rise in retail sales tomorrow as well. Right now the market is expecting flat Canadian retail sales, so it will not take much for the number to surprise to the upside.

The Australian and New Zealand dollars also extended their gains on the back of higher gold prices despite mixed economic data. Australian new home sales dropped 8.6 per cent while the New Zealand trade deficit narrowed from NZD$2.2bn to NZD$2.91bn.

Can Europe Handle 1.40 Euro?

Back in 2005 when the euro was trading at 1.17, we used to say that the path to a stronger euro was through a weaker one.

Now, we hold the reverse view, which is that the euro's strength will be what triggers a weaker currency. Since the Eurozone is heavily dependent upon exports a weak currency goes a long way in boosting growth while a strong one will crimp it.

Therefore we expect Eurozone economic data to begin to deteriorate in the months forward as 1.40 euro begins to have a meaningful impact on the overall economy.

At this point, there is no need for a further interest rate hike from the European Central Bank (ECB) because even though rising oil prices are stoking inflationary pressures, a rising currency will offset some of that pressure.

Going forward we also expect the corporate sector to loudly complain about the strength of the euro. The French have been screaming for months and the Germans should soon follow suit. This may eventually force ECB President Jean-Claude Trichet to drop his optimistic outlook, which would trigger a top in the euro.

Carry Trade Obsession Dies

Over the past few months, the dollar's performance against the Japanese Yen has diverged significantly from its performance against the other majors like the euro and British pound, but over the past few days, we have finally seen that relationship normalise.

This means that when the dollar weakens, it weakens against every currency including the Japanese yen. This suggests that the market is no longer obsessed with carry trades.

In fact, yesterday when the Dow rallied, carry trades did not follow suit and today, they continued lower. In the grand scheme of things, the yen crosses are still in corrective mode after the carry collapsed back in mid July.

The outlook for the US economy is unclear which gives traders no reason to jump back into risky trades.

British Pound Rallies on Strong Retail Sales

The British pound continued to lose ground against the euro but rallied back above 2.0 against the US dollar today.

Retail sales, monetary supply and mortgage approvals were hot, which offset the criticism Bank of England Governor Mervyn King faced as he explained the central bank's reaction to the problems at Northern Rock to a committee of MPs.

Today's UK data indicates that the economy is still holding steady, but that will not stop the Bank of England from being less hawkish since inflation remains below their target. Meanwhile the UK continues to benefit from merger and acquisition flow.

Qatar Investment Authority and Borse Dubai have snapped up 48 per cent of the London Stock Exchange.