EUR/USD Forecast After the ECB Rate Decision

01/16/2009 10:48 am EST

Focus: FOREX

The European Central Bank has lowered its benchmark interest rate by 50 bps to 2%, yet in our opinion, the rate cut came a bit too late, and we expect more EUR/USD weakness going forward on speculation that we may have a considerable deterioration of the euro zone economy in 2009.

The Euro Zone Is Experiencing a Significant Slowdown, Trichet Said

In the introductory statement ahead of the regular press conference, Jean-Claude Trichet sounded very pessimistic. The president of the ECB said the euro zone is experiencing a significant slowdown and “today’s decision takes into account that inflationary pressures have continued to diminish, owing in particular to the further weakening in the economic outlook.” Looking further ahead, he said that we may “continue to see global economic weakness and very sluggish domestic demand persisting in the coming quarters as the impact of the financial tensions on activity continues.”

Euro/Dollar Forecast for 2009 (Updated)

It is always difficult to make exchange rate forecasts, particularly when the currency market is very volatile.  Even so, in this article, we argue that a considerable deterioration of the euro zone economy in 2009 could lead to a significant shift of interest rate differentials in favor of the US dollar and keep the EUR/USD under pressure over the next few months. Indeed, recent economic data points toward weakening of real GDP growth in the euro zone economy, and a more accommodative monetary policy by the European Central Bank could be needed to prevent the region from falling into a much deeper recession. On the other hand, the recent selloff in commodities, particularly in oil, should alleviate some downward pressure from the US economy, which has been running a current account deficit of nearly 5% of GDP.

Chart
Source: Bloomberg

The ECB Underestimated the Size of the Financial Crisis

The biggest housing and credit bubble in history continues to threaten the entire global financial system, and the once-resilient euro zone economy is slowly succumbing to tight credit conditions and a slowing global economy. Initially, European policy leaders thought the financial crisis would be confined to the United States, and the ECB was slower to act than the Federal Reserve. Inflation in the euro zone was well above a level consistent with price stability, and the ECB was concerned with second-round effects of energy prices in wage and price setting. However, the credit storm that began in the US ended up affecting the euro zone and European banks were forced to write off $229 billion out of a global total of $588 billion in losses related the collapse of the US subprime market. While no one can deny that Jean-Claude Trichet, the ECB president, has done a lot to boost the euro as a credible alternative for the US dollar, it is also becoming clear that the ECB perhaps underestimated the size of the financial crisis by keeping interest rates too high for too long. In fact, the euro zone is now in a technical recession and facing the most serious test since the euro was introduced to the world financial markets in 1999.

Risks for This Trade

In 2008, the US dollar appreciated against several of the world’s most heavily traded currencies. To some extent, investors were reluctant to take leveraged positions on higher yielding currencies, and the US dollar was helped by a strong demand from financial institutions seeking a safe-haven currency. However, holding a long position in the US dollar also involves some risks. In fact, the US economy is likely to continue to face substantial challenges in 2009, including further job losses and a rapid deleveraging in the financial sector. In addition, some investors are concerned with the fiscal impact of the rescue plan, which could cost almost 5% of GDP. Currently, the United States federal government runs a deficit of $438 billion, or 3% of gross domestic product, and the bailout plan could push the fiscal deficit next year to $1 trillion, or 7% of GDP.

By Antonio Sousa, Chief Strategist, DailyFX.com

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