Why the Euro Is “The Teflon Currency”

10/05/2010 12:01 am EST

Focus: FOREX

Kathy Lien

Managing Director and Co-Founder BKForex LLC, BK Asset Management

After a one-day relief rally, the US dollar resumed its slide, falling sharply against all of the major currencies. September has been a horrible month for those traders who were long dollars and a fantastic one for those that have been short. Over the past month, the greenback lost value against every major currency, with the strongest losses seen against the euro and Australian dollar. Unlike the aussie, which has benefitted from the Reserve Bank’s hawkish comments, the rally in the euro was driven primarily by position adjustments. In August, many investors were still skeptical about the outlook for the euro zone and worried that the debt problems in Europe would turn into a crisis. However, that has not happened over the past month, and in fact, recent economic data has shown significant signs of improvement within the euro zone.

When the sentiment in the market changes as much as it has over the past month, it gives the moves in the foreign exchange market fundamental support, explaining why they can become so overextended. It also doesn’t hurt when you have Fed presidents such as Evans saying the “Challenges for (the) US are far stronger than Europe.” However, Evans is right to point out that the euro zone is recovering the way the US is recovering. The US experienced very strong GDP growth between the third quarter of 2009 and the first quarter of 2010. For example, the economy expanded by 5% in Q4 and by 3.7% in Q1. The second quarter wasn’t that bad either, with GDP rising by 1.7%. During that same time period, the strongest GDP growth experienced in the euro zone was in Q2, when the economy grew by 1.0%. Between Q3 of 2009 and Q1 of 2010, average quarterly GDP growth in the euro zone was a meager 0.45%. 

So what is happening right now is that the euro zone is catching up with the US because everything in the euro zone has been happening with a lag. The region is only beginning to experience the strong recovery enjoyed by the US a few quarters ago. This suggests that even though euro zone growth could accelerate over the next quarter or two, it will eventually hit a rough patch similar to the one that the US is currently experiencing. A slowdown could easily be triggered by austerity programs and a strong currency, however, these are factors that will not come into play until much later. For the time being, the prospect of additional easing by the Federal Reserve is still the dominant driver of currency movements. This has caused investors and central banks around the world to move out of dollars, and the euro has been one of the biggest beneficiaries. As long as investors continue to believe that the Fed will announce asset purchases, the EUR/USD will be on its way to 1.40.

More Fed Officials Back QE

Based upon the latest comments from Federal Reserve presidents, we now know that Dudley and Evans also support more easing. According to Dudley, more action from the Fed is warranted unless the outlook changes. Evans appeared to be in agreement when he said current unemployment and inflation levels “May call for more Fed easing.” In addition to Dudley and Evans, Rosengren also appears to favor additional easing. Plosser and Hoenig are against it, while Kocherlakota and Pianalto appear to be neutral. Clearly, there is not a consensus within the central bank, and because of that, the next few weeks of economic data will be very important in helping some of the undecided FOMC voters to make their decision. Non-farm payrolls are due for release next week, and it is one of those reports that have the power to shift the market and the Federal Reserve’s expectations. The very early forecast for non-farm payrolls shows analysts expecting job growth to turn positive after three straight months of job losses. If non-farm payrolls print positive, the case for a smaller or delayed asset purchase program would be stronger, which could provide relief for the US dollar. If it prints negative, the dollar will probably come under additional selling pressure as the case for more QE grows.

This morning’s economic reports were mixed. Personal income and personal spending increased in the month of August, which is in line with the rise that we have seen in retail sales and average hourly earnings. Incomes increased 0.5%, while spending rose 0.4% thanks to the resumption of extended and emergency unemployment benefits. Just as we have seen in the retail sales report, a pickup in back to school spending helped to lift demand. The PCE core and PCE deflator, which are inflation measures, remained unchanged. The University of Michigan consumer sentiment number was also revised higher, from 66.6 to 68.2. This leaves consumer sentiment at the weakest level since November 2009. Construction spending also rebounded by 0.4% after falling 1.4% the previous month. The manufacturing sector has not fared as well, with the ISM manufacturing index dropping from 56.3 to 54.4, a sign that activity is slowing. The guts of the report were even weaker because all of the underlying components deteriorated except for prices paid and inventories. Yet as long as the ISM index remains above 50, manufacturing activity is growing.  In addition to the non-farm payrolls report, factory orders, pending home sales, and service sector ISM are also scheduled for release next week.

EUR: “The Teflon Currency” Shrugs Off Weak Data

The euro broke above the 1.37 level this morning to reach a new five-month high against the US dollar. The “Teflon currency,” to which no bad economic news seems to stick, continued to rise despite weaker-than-expected economic data. German retail sales fell 0.2% in August, which was an unexpected decline following the improvement in the labor market and pickup in consumer confidence. Although the retail sales report can be quite volatile on a month-to-month basis, if consumer spending does not rebound next month, it will be quite worrisome because tight-fisted consumers are not helpful at all. The final manufacturing activity figure for the euro zone was revised slightly higher from 53.6 to 53.7 thanks to stronger manufacturing activity in France. 

Unfortunately, manufacturing numbers in Germany and Italy were revised lower. Comments from IMF’s Strauss-Kahn may have provided some support for the euro as he does not expect the euro rescue fund to be activated because of Ireland. Despite “Positive signs of economic recovery,” EU finance ministers believe that the recovery “Still remains uncertain.” The European Central Bank has a monetary policy announcement next week and traders will be looking to Trichet’s press conference for any clues on whether the strong currency is starting to worry the central bank. Meanwhile, the Swiss franc is trading lower against the euro following weaker economic data. The annualized pace of Swiss retail sales growth slowed materially in the month of August, a sign that the recovery may be losing momentum. Manufacturing activity in Switzerland also expanded at a much slower pace in September, which could be partially attributed to the strength of the currency.

By Kathy Lien, currency analyst, KathyLien.com

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