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March 24th 2009

USD/EUR: Conflicting Signals Make Predictions Difficult

If you read analysts’ coverage of the Dollar decline (and consequent Euro rally), there is an even divide over whether it is sustainable. Economic data and technical indicators paint a nuanced picture, such that this kind of uncertainty is understandable.
On the one hand are the the Dollar bears, who point to an economic recession that continues to deepen, and the seeming complacency of the Federal Reserve Bank towards inflation. If there is any doubt as to how the forex markets feel about the Fed’s plan to purchase over $1 Trillion in US government bonds, consider that the the Dollar just recorded its worst weekly performance in 24 years, while the Euro simultaneously recorded its strongest week since its inception in 1999. There’s not much nuance there.

Meanwhile, the economic picture is equally depressing. Summarized by Kathy Lien of GFT Forex:

The Empire state manufacturing survey plunged to a record low in the month of March while Industrial production fell 1.4 percent, driving capacity utilization back to its record lows.  Foreign investors reduced their holdings of U.S. assets by the largest amount since August 2007. Homebuilder confidence held near its record lows in the month of March as the slump in the real estate sector shows no signs of easing.

Unfortunately, there is a contradiction in the argument that the Dollar is being plagued both by economic collapse and by the risk of inflation. Writes Marc Chandler, head of FX strategy at Brown Brothers Harriman, “The pessimist camp wants it both ways. The US is going down the same path as Japan, where the end of a real estate bubble led to a banking crisis and a deep economic contraction. And they want to caution that printing of money will boost interest rates, fuel inflation and debase the currency.” He points out that history, as well as common sense, contradict this line of thinking.
Those that remain bullish on the Dollar argue that the Euro rally is a function of technical, rather than fundamental developments. First of all, we are approaching the end of a fiscal quarter. As evidenced by the Dollar decline which took place at the end of December, these periods are usually marked by portfolio rebalancing and hedging, such that it’s not uncommon to see large swings in forex markets. From a technical standpoint, when the Dollar failed to breach the $1.30 level against the Euro, many short sellers were probably forced to cover their positions, which accelerated the Dollar’s decline.

Bulls are confident that the pickup in risk-taking which catalyzed a 20% stock market rise is here to stay. “The move to the upside came after the government described a plan that will…generate $500 billion, and possibly $1 trillion over time, to buy hard-to-trade and badly deteriorated assets from banks.” The banks will be recapitalized, the financial system is being repaired, and everything will be okay, right?

The markets are certainly prone to false-starts. I can count numerous instances of government officials and market commentators insisting that “the worst is behind us.” Nevertheless, if this time proves to be different, it could be bearish for the Dollar, whose role as ‘safe-haven’ currency would likely be eroded by a positive change in market sentiment.

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Posted by Adam Kritzer | in Economic Indicators, Euro, US Dollar | 6 Comments »

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6 Comments of “USD/EUR: Conflicting Signals Make Predictions Difficult”

  1. Yokie Says:

    interesting analysis, but could you explain what effect does the speech given by timothy geithner yesterday to USD?

  2. Non-believer Says:

    It is extremely hard to comprehend how the run up of the Euro against the dollar is sustainable. The countries of the EU don’t have the basic depth of resources (material, infrastructure, and labor) as that behind the dollar. Some Eastern European economies are still fragile and dependent on the more wealthy nations.

  3. noobtrader Says:

    Easter European economies shouldn’t be credited as major players or prime causes regarding the evolution of the Euro, everybody got hit mostly due to the recession, which in the end lowered the people’s purchasing power. That can be easily noticed while looking into trade balance reports, inflation and other relevant announcements.

    Regarding the Eastern European countries and their relationship with the EU, should I remind you that the EU accepted them although some joining criteria weren’t met. Yet I subscribe to the fact that it’s quite hard to predict what will the Euro do. Will rise against the Dollar or will it fall? My guess is that it will fall the following week, the US economy is recovering, most people have hope in the current administration, and this kind of momentum has a certain effect.

    The major issue proposed these days is the situation of Eastern European countries like Romania that recently accepted IMF loans. This will have an impact on the Euro in a negative way.

  4. Forex Links For The Weekend Says:

    […] Adam Kitzer, of Forex Blog, writes about how contradicting signals in EUR/USD make it hard to predict. […]

  5. Mordan Says:

    it is more about inflation/deflation argument.
    the dollar rally will resume if deflation or disinflation continues

  6. Greg Says:

    I am not seeing any major move of the Euro against the Dollar. Same fundamental issues are on both sides of the pond. Yen have been treating me well, and I think better opportunities are out there.

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