Fed sees growth risks return, puts exit discussion on hold

US growth doubts weigh on dollar

This week the euro continued its rally against the US dollar and against most commodity and emerging market currencies. The majority of European currencies have managed to hold their ground versus the euro – some (such as the pound Sterling and the Scandinavian currencies) more than others (e.g. the Czech koruna, the Hungarian forint and the Swiss franc). The yen, like the latter, has slipped somewhat against the euro.

The euro gained over 3 cents versus the dollar and is currently approaching 1.30. Its sharp rebound is partly due to thin trading. The holiday season is starting to have an impact on sales volumes and exchange rate movements. The unwinding of short euro positions, which had been built up at the height of the debt crisis, also boosted the euro. The main reason for the euro’s recovery, however, was probably a shift in market focus. For weeks on end, the spotlight had been solely on the credit risks of European countries and banks. The implementation of a rescue package for countries potentially at risk of default at the eurozone level and austerity packages at the national level has restored investors’ confidence to some extent. Markets are now focusing more on the relative growth outlook for the major economies and monetary policy stance.

Thus the forex markets’ reaction pattern is changing. Up till recently, the dollar has served as a safe haven currency, when equity markets, economic data or credit spreads have sent out crisis signals. The risk on/risk off mechanism seems to be becoming less significant, and the more traditional correlation between growth and interest rate differentials and the exchange rate is gaining importance. And here the US have fallen behind the eurozone.

Eurozone: Confidence is slowly returning

Compared to the crisis scenarios acted out in the markets over the last few weeks, the European economy is doing quite well so far. Second quarter data are expected to be strong, and according to the economic indicators, an end of the expansion is not yet in sight. The German economy, the eurozone’s main growth driver, seems to be in quite good shape.

At the same time, money market rates in the eurozone are climbing. Even though the ECB claims not to have changed its monetary policy stance, the withdrawal of liquidity, which had started at the beginning of July when the €442bn one-year tender matured, is continuing. This week too, a good €15bn of central bank loans were not renewed. The Eonia overnight rate has now risen to almost 0.50%, the 3-month Euribor stands at 0.86%. The more liquidity the ECB drains from the system, the more money market rates are determined by the main refinancing rate, which, at 1%, is quite high compared to that of other countries. Simultaneously, 2-year Bund yields have risen from 0.55% at the beginning of the month to 0.80% currently.

USA: Hopes are dashed

The situation in the US is exactly the other way round: after production had picked up, employment had started to rise and even the housing market had shown signs of improvement, markets had begun to hope that the upswing was gathering pace. These hopes have been dashed, however, by the latest data. After the expiration of the homebuyer tax credit, the housing market plummeted; excluding temporary Census-related hiring, the number of new jobs created is so small that the unemployment rate is still almost at its peak. The latest economic data published this week were also disappointing: retails sales declined again in June; industrial production fell in June, and the first regional surveys show that the weak trend is set to continue in July; furthermore, the trade balance deteriorated again in June.

The Fed is more downbeat too. The minutes of the FOMC meeting of 23 June state that the economic outlook has deteriorated somewhat; a number of committee members see an increase of downside risks. The changes in the outlook are “relatively modest”, however, and do not warrant any additional monetary policy accommodation.

That sounds relatively harmless at first, just like a confirmation of the present monetary policy stance. It should be borne in mind, however, that the discussions in the central bank have completely changed direction. Up until a few weeks ago, the debate had focused on identifying the right time to embark on an exit from the extremely expansive monetary policy. Now, all of a sudden, the question whether the central bank should implement further monetary easing measures, to prevent the recovery from faltering, has taken centre stage.

The change in discussion is reflected in the development of interest rates. On Thursday, 2-year T-note yields fell for a time to their lowest level ever, 0.58%, and now stand at 0.60% – the same level as at the beginning of the month. In a comparison between Treasury and Bund yields, within the space of a mere six weeks, spreads have altered from a significant interest rate advantage of around 30 points for the US bond to a disadvantage of 20 points.

We are expecting the situation responsible for these developments – weakness in the US, relatively robust economy with tendency for higher money market rates in the eurozone – to continue over the next few weeks. Against this backdrop, the euro should remain well supported. However, beyond 1.30, the air will get thinner for EURUSD.