Euro Makes New Record High Despite Sharp Drop in Business Confidence

DailyFX Fundamentals 09-25-07

By Kathy Lien, Chief Strategist of DailyFX.com

US Dollar Hits an All Time Low; It Only Gets Worse

The US dollar fell to a new all time low of 1.4154 against the euro on the back of continued deterioration in the US economy.

Traders and investors are selling dollars as the outlook for consumer spending becomes bleaker with each passing day. Consumer confidence dropped to a two year low in the month of September while sales of existing homes fell to a five year low.

We are actually surprised that there wasn't an even larger drop given the deterioration in the labour markets, tight credit conditions and rising energy prices. October is the month when sub-prime adjustable rate mortgage resets will hit a peak of $50bn. This is the largest amount on record and suggests that the cycle of major sub-prime related losses at hedge funds and banks could begin once again.

Generally, the increase in mortgage payments will lead to an increase in foreclosures, so now may not be the time to be complacent about taking risk. The drop in confidence and home sales only reinforces the need for the Federal Reserve to continue lowering interest rates.

We expect another 50bp of easing by Christmas followed by another 50bp before the middle of next year. The next Non-Farm payrolls report is not expected to be pretty either. On top of the layoffs that have already been announced in the financial sector, workers at General Motors held their first nationwide strike in 25 years.

Some 73,000 workers have been displaced and 30,000 are expected to be pushed off the job. If this is not resolved soon, it will have a meaningful impact on non-farm payrolls which will naturally dovetail into further weakness for the US economy. The question now is will a recession happen; we are discussing this on the DailyFX Forum.

Meanwhile the only piece of good news was the Richmond manufacturing index which jumped from seven to 14 in September, the highest level since April 2006. The manufacturing sector is expected to be one of the biggest beneficiaries of dollar weakness which is why tomorrow's durable goods may not be as bad as analysts are currently predicting.

Euro Makes New Record High Despite Sharp Drop in Business Confidence

The euro made a new record high today despite larger than expected drops in German business confidence and import prices. Economic data out of Europe continues to get worse and if the euro does not stop rising, the European Central Bank (ECB) will be forced to verbally intervene in the currency.

Don't forget that the euro topped out in late 2004 after ECB President Jean-Claude Trichet called the moves brutal and he may have to do so again as German business fell to a 19 month low in September. This is a result of deteriorating credit conditions, a strengthening currency and tight monetary policy.

As an export dependent nation, the Eurozone has a lot to lose if the euro continues to rise. The only major benefit of a strengthening currency is lower inflationary pressures. We are already seeing the initial impact with import prices falling for the first time in nearly 2.5 years.

Less inflationary pressure means less pressure on the ECB to raise interest rates. If we see a material slowdown in economic data, softer inflation may actually give the central bank the flexibility it needs to begin talking about lowering interest rates. This of course is a few months off at the earliest, but it is a factor that is certainly worth watching.

There is not much on the Eurozone calendar tomorrow, but Switzerland has leading indicators due for release, which is expected to be weaker.

Bank of Canada Dodge Only Mildly Concerned about CAD Strength

Although no Canadian economic data was released today, the markets were eagerly awaiting the comments from Bank of Canada Governor David Dodge. With the CAD at parity with the US dollar, any changes to the central bank's monetary policy stance could either trigger a sharp recovery in the loonie or further gains.

However instead, Dodge walked a very fine line by saying that interest rates were appropriate but the loonie had strengthened above their assumed trading range and because of that, they need to evaluate its cause.

Meanwhile the Australian dollar continued to rally on the back of higher gold prices and optimistic comments from Reserve Bank of Australia (RBA) Governor Rick Battelino. The New Zealand dollar did not fare as well ahead of its August trade balance numbers unfortunately. Its five day rally ended today.

British Pound Hit by News that UK has only £4.4bn to Cover Bank Deposits

With no major economic data released this morning, the British pound came under pressure after the UK Telegraph reported that the Bank of England only has £4.4m to cover UK bank deposits in the case of a failure.

The paper compares this amount to the $49bn held by the Federal Deposit Insurance Corporation (FDIC) in the US. Although these numbers are true, the information is a bit distorting. The policies in the UK and the US are very different.

The Financial Services Compensation Scheme (FSCS), which is the UK version of the FDIC, holds no funds and only raises those funds in the event of a bank failure. The US on the other hand does have that money readily available in case of a collapse.

The amount held by the FDIC is still small; it represents only 1.5 per cent of total US deposits. The UK does guarantee less deposit than the US (£70,000 in UK and $100,000 in the US) and depositors need to wait, which is a problem, but things in the UK are not as bad as the article suggests.

Tepid Rally in US Stocks Leads to Mixed Performance in Japanese Yen Crosses

The Dow rallied by a lackluster 19 points which explains why the Japanese yen crosses are mixed on the day. The corporate service price index rose less than expected in August indicating that inflation is not really a problem.

This reinforces the market's belief that interest rates in Japan will not be increased anytime soon. The trade balance is due for release tonight, but we do not expect that to be particularly market moving either.

Instead, the yen crosses will continue to move in lockstep with the Dow.