Chinese Exporters Dump Dollar

The anecdotal evidence that China is diversifying its forex exposure away from the Dollar continues to mount. To date, most of the focus has centered around the Central Bank of China, which is passively diversifying its reserves into European and higher-risk assets. Apparently, Chinese exporters are also getting nervous about the impact of a falling Dollar on their respective bottom lines. The RMB has risen 11% since the beginning of 2007, which means Chinese companies now receive 11% less on sales to destinations abroad than they did for equal-priced goods in 2007. As a result, some companies have taken to quoting prices in Euros or to adjusting Dollar-denominated prices every few months. Other companies are building assumptions of a more valuable RMB into their profit models, and setting prices accordingly. The New York Times reports:

“We are gradually increasing our emphasis on the domestic market until we can forget about the export market, because the profit margins on exports are so thin,” [said one exporter].

Read More: Some Chinese Exporters Prefer Euros to Dollars

April Marks Dollar Turnaround

Earlier this week, the Forex Blog speculated that the tide was turning on the Euro, which  had retreated from the $1.60 threshold. Sure enough, the month of April saw the best monthly performance by the Dollar in over two years. The sudden about-face by the Dollar stems from changes in interest rate expectations. Only a couple weeks ago, the consensus among investors was that the Fed would cut rates further at its next meeting; the only point of uncertainty was whether rates would be cut by 25 or 50 basis points.

As of today, however, there is only a 25% chance that the Fed will cut rates at all, if you go by futures prices. Regarding the Euro, investors are no longer so sure that the ECB will hike rates in response to surging inflation. In short, the new consensus is that the US/EU interest rate differential has stabilized. Then there is the economic picture; investors have "chosen" to be pleasantly surprised by the most recent economic data. While the economic downturn still seems inevitable, it may not be as severe as investors had previously feared. Reuters reports:

In contrast to slightly stronger U.S. data, the Ifo German business sentiment index this week showed the biggest monthly fall since September 2001.

Read More: Dollar heads for best month in 2-1/2 years

Forwards Gain Retail Appeal

The anecdotal evidence for surging retail interest in forex is cropping up everywhere. Moreover, investors are no longer even limiting themselves to the spot market, utilizing derivatives to speculate on future exchange rates. In the UK, for example, 10% of investors intending to purchase real estate in the EU are utilizing forward agreements to hedge their exposure to the Euro, which has risen 10% against the Pound since the beginning of 2008. Evidently, prospective home buyers are hoping that the Euro returns to 2007 levels, which would significantly lower the cost of buying property there. However, if the Euro continues to appreciate, such investors could end up losing more than they bargained for. Homes Worldwide reports:

Even the movement in the markets over a couple of days can make the difference between owning a property and no longer being able to afford it.

Read More: Brits Gambling On Volatile Currency Markets

Chinks in the Euro's Armor

2008 has witnessed a rapid appreciation in the Euro, which recently breached the psychologically important $1.60 barrier. Last week, however, the Dollar dramatically reversed course, leading many traders to speculate that the Euro's best days may be temporarily behind it. There are two ideas underlying this theory. First, the Federal Reserve Bank is probably near the end of its tightening cycle, while the ECB has yet to begin. In addition, recent economic data suggests that the Euro-zone economy, which has appeared recession-proof in spite of the credit crisis, may soon falter. The best-case scenario, according to Dollar bulls, would be a loosening of monetary policy in the EU simultaneous with tightening in the US. If such a scenario were to obtain, it would bridge the interest rate differential between the two economies, which many believe is behind the weakness in the Dollar. The Wall Street Journal reports:

If bad news out of Europe starts to accumulate and the Fed stands pat, the dollar’s slide could taper off.

Read More: An Endgame for the Euro?

G7 Warns of Volatility

For the last few months, EU politicians have whined about the appreciating Euro.  Aside from some token comments by the European Central Bank, however, the world failed to pay heed.  That changed last week, when the G7 formally and harshly warned that volatility in forex markets risks harming the global economy. But talk is cheap, and the real question is whether it will be backed up by action. Most analysts reckon that it will be difficult and would take time for the governments of the EU, US, and Japan, at the very least, to put together a coordinated plan of intervention.  Besides, the window has probably closed on action by Central Banks, which have conducted monetary policy irrespective of currency valuations. Reuters reports:

The U.S. Federal Reserve Board [is] nearing the end of its interest rate-cutting cycle, the European Central Bank [is] likely to reduce rates before the end of the year, and things might not get much worse for the U.S. economy. That suggests the dollar may recover in the coming months, with or without official intervention.

Read More: G-7 leaders talk tough on currency markets

Economists: Euro Correction Inevitable

In a research note, two economists from Morgan Stanley predicted that the Euro will soon come crashing down, failing in its bid to rival the Dollar as a viable reserve currency. They observed that in the beginning of the decade, the Euro was viewed as joke from an economic standpoint. Since long-term economic fundamentals can't reverse themselves in only a few years, they reasoned that the Euro's rise must instead be a product of financial (capital flows) trends. Furthermore, as the EU becomes further integrated, a need will develop to diversify capital outside of the EU, thus reversing the trend of the last few years of diversification within the EU. The Globe and Mail reports:

The euro is overvalued because institutional investors...world have been diversifying out of their home markets at the same time as European investors have largely been diversifying within their home market.

Read More: The euro as reserve currency? Hah!

ECB Holds Rates

The European Central Bank (ECB) has decided to hold its benchmark interest rate at 4%.  Despite signs that the EU economy is slowing, inflation is hovering around 3.5%, and the ECB has announced that its priority will be to maintain price stability. Jean Claude Trichet, President of the ECB, declared during the accompanying news conference that he "deplores" volatility in the forex markets, an indication that he is concerned that the Euro is appreciating too rapidly.  It doesn't help the Euro's cause that the Bank of England lowered its benchmark lending rate to 5% earlier in the week and that the Fed is also in the process of easing monetary policy. Both the US Dollar and British Pound recently touched record lows against the Euro.

Read More: Trichet says deplores excessive forex volatility

Euro Could Replace Dollar

Two American economists recently conducted a computer simulation to determine how the role of the US Dollar as the world's reserve currency will evolve over the next decade.  Their hypothesis- that the Dollar's preeminence would be maintained- was contradicted by the simulation leading them to conclude that the Euro will overtake the Dollar within the next 10-15 years. This may be hard for many analysts to stomach, since the Dollar's share in global currency reserves is 66%, compared to the Euro's 25%. In addition, the Dollar has held its title for nearly 150 years, and it's difficult to fathom its being replaced.

However, two factors have emerged within the last 10 years, lending support to the argument.  First, the US twin deficits have exploded; the current account deficit approximates $800 Billion and the national debt is estimated at $9.4 Trillion. Second, prior to the inception of the Euro, there didn't exist a credible alternative to the Dollar. The Deutsch Mark and Japanese Yen initially seemed like potential candidates, but the German currency was folded into the Euro, and the Japanese economy has soured and taken over by deflation. Then there are peripheral factors, like US monetary policy, which is facilitating inflation and eroding the Dollar.  There are also signs that a neo-imperialist foreign policy has overstretched the US, and foreign Central Banks are becoming nervous.  The Financial Times reports:

Many developing countries will find it harder to maintain their dollar pegs. They may be reluctant to drop them now but there will come a point when the rise in inflationary pressures becomes unbearable.

Read More: This crisis could bring the euro centre-stage

Bank Collapses, Dollar Plummets

Over the weekend, Bear Stearns, a prestigious American investment bank, hurriedly scrambled to find a buyer in order to avoid having to file for bankruptcy. While a buyer (JP Morgan) was ultimately secured, investors remained jittery, as the collapse of this magnitude is virtually unprecedented.  When forex markets re-opened on Monday, the Dollar crashed against all of the world's major currencies, namely the Euro and the Yen. Furthermore, analysts are now beginning to view forex intervention as increasingly likely. It's still unclear whether the Bank of Japan or the European Central Bank (with or without support from the Fed) would spearhead any such intervention.  At the breakneck speed at which events are unfolding, however, no one will be surprised if a plan is quickly cobbled together. The Wall Street Journal reports:

"Were such intervention to be seen, (the euro) could briefly trade down to $1.55, yet unless the (ECB) is prepared to back up such intervention with a rate cut, intervention will be futile," said [one analyst].

Read More: Dollar's Slide Keeps Pace

Dollar Falls to Record Lows

Over the last couple weeks, the Dollar has plummeted against all of the major currencies, falling below the $1.50 mark against the Euro for the first time ever.  It seems investors are reacting to a spate of negative economic data which are painting an increasingly bearish picture for the US economy.  In addition, the Fed seems likely to lower rates further while the ECB will maintain rates at current levels. For a brief period, talk of recession was actually helping the Dollar, as investors predicted that the global economy would be harmed more than the US economy, but it looks like that period has passed. As a result, the EU is growing increasingly alarmed, and the pressure is building for some kind of intervention.   AFX News Limited reports:

Euro group president Jean-Claude Juncker said currency markets are overreacting to the short-term outlook for the US economy. " We don't like excessive volatility in exchange rates," Juncker said.

Read More: Euro group's Juncker says currency markets reacting too hastily to US outlook

Fed vs ECB

Yesterday, the European Central Bank (ECB) maintained its benchmark lending rate at 4%.  Meanwhile, America's Federal Reserve Bank has cut rates by 2.25% over the last six months.  For years, the ECB existed entirely in the shadow of the Fed and conducted monetary policy accordingly, but in this latest downturn, it seems to have broken free. The reason for the split can be found in the Central Banks' different mandates: the Fed aims to promote growth, while the ECB is charged primarily with creating price stability. Thus, the ECB can easily avoid succumbing to analysts' expectations that it will ultimately lower rates.  In addition, while EU politicians are pressuring the ECB to hold down the common currency, the ECB's mandate is actually supported by the expensive Euro because it lowers the cost of imports. The New York Times reports:

Mr. Trichet has long held that central banks do their best work when their threats to raise interest rates deter inflationary actions in the first place, avoiding the need for excessive swings in the benchmark rate.  [He] called this concept “credible alertness.”

Read More: In Europe, Central Banking Is Different

Dollar Notches Stellar Weekly Performance

Last week, the USD recorded its best weekly performance since 2006, rising 3 cents against its chief rival, the Euro.  Apparently, analysts are becoming increasingly pessimistic about the effect of the America recession on the global economy.  The consensus is now that a dampened global economy will induce a trend towards risk aversion, which favors the world's #1 and #2 reserve currencies, the Dollar and the Euro, respectively.  However, it also appears the near-term economic prospects for Europe are less rosy than originally forecast,.  Thus, if last week is any indication, the Dollar should receive a larger proportion of risk-averse capital. Reuters reports:

"Despite a torrent of bad economic news the dollar has been on a tear this week, as the currency market recognized the fact that the slowdown in U.S. economic activity is likely to drag down growth in the rest of the G10 universe..."

Read More: Dollar set for biggest weekly rise since June 2006

ECB Holds Interest Rates

At its meeting last week, the European Central Bank (ECB) held its Euro-zone benchmark lending rate at 4.00%.  While the decision itself came as no surprise, analysts were nonetheless waiting with baited breath to hear what remarks would accompany it.  Jean Claude Trichet, the Bank's President, eased up on hawkish comments he made the previous month, when he signaled that his primary concern was inflation rather than the risk of economic recession. This month, however, he changed his rhetoric markedly, indicating that the ECB was less willing to preempt rising price levels and would instead shift its focus to the possibility of a 'sharp slowing' of EU growth. Forbes reports:

Our view [is] that rate hikes are definitely off the agenda at this stage and by bringing a greater degree of uncertainty on the growth assessment, the ECB may be getting ready for a shift towards a more dovish policy language.

Read More: Euro sags after Trichet tones down hawkish stance

ECB to Avoid Rate Cuts

When America's dot-com bubble collapsed in 2001, the Federal Reserve Bank moved quickly to quell the panic by slashing interest rates.  The European Central Bank (ECB), on the other hand, was adamant that it would not have to follow suit since the European and American economies were no longer so intertwined.  Several months later, it became increasingly clear that the ECB was wrong, and it was ultimately forced to lower rates.  Now, some analysts fear that history is repeating itself, as America's housing crisis threatens to run a similar course as the collapse of the stock market bubble. The Fed has lowered interest rates twice in the last few months, while the ECB has yet to act, insisting that its primary concern is inflation. For now, the interest rate differential is supporting the Euro, but if the ECB falls behind the curve, a stagnating EU economy could bring down the common currency.  The New York Times reports:

But when it comes to the economy, Europe remains optimistic it can decouple itself and withstand collateral damage from a possible recession in the United States.

Read More: Why the European Bank Is Sitting Back

Central Banks in the News

As we wrote last week, the direction of the Dollar may be influenced more by external economic events rather than by internal activity.  Accordingly, it would behoove forex traders to direct their attention away from the Fed and towards the Bank of England and the European Central Bank, both of which face important monetary policy decisions later in the month. With regard to the Bank of England, futures markets have priced in a 2/3 chance that rates will be cut by 25 basis points. In the case of the ECB, the markets are expecting rates to be maintained at current levels. However, analysts will be scrutinizing the Banks' respective press releases and monitoring other developments in this area due to the implications for the US-EU-Britain interest rate differential.  Reuters reports:

Some analysts think that hawkish comments from Trichet will be brushed aside with weaker economic data leading to the prospect of falling euro zone rates later in the year.

Read More: Pound down, others flat before ECB, BoE decisions

A reprieve for the Dollar?

The last two years have witnessed a veritable collapse in the value of the Dollar, which has declined over 25% against the Euro, alone.  While opinion remains divided, many analysts are predicting a (temporary) cessation in the Dollar’s downward slide.  The reasoning is that the worst possible scenario involving the American housing crisis has already been priced into the Dollar.  Furthermore, experts argue that the inevitable loosening of American monetary policy will help boost the American economy by preventing it from slipping into recession. Finally, there is the notion that China will begin to take steps to appreciate its currency relative to the Euro, which has actually risen against the RMB.  The law of triangular arbitrage requires that any rise in the Euro against the Yuan must be matched by a proportional rise in either the Dollar/Euro or the Dollar/RMB rate, the latter of which seems unlikely.  Dow Jones reports:

There is also the possibility that official Chinese purchases of the euro could decline after last week's visit by a delegation from the European Central Bank to Beijing, anxious to reduce upward pressure on the single currency.

Read More: Chances Of Dollar Bounce May Be Rising

EU Joins US in Calling for Yuan Revaluation

In the campaign to pressure China into revaluing the Yuan, the US has by far been the loudest voice.  However, the rapid decline of the USD may have unintentionally earned the US a new ally in its fight: the EU.  Since the Chinese Yuan is essentially pegged to the USD, and the USD has declined against the Euro, the law of triangular arbitrage is such that the Euro has actually appreciated significantly against the Chinese Yuan.  EU officials are no longer standing by idly, since the exchange rate is beginning to deal serious harm to its balance of trade.  In fact, the EU now occupies third position on the list of countries with the largest trade deficits with China.  Because of the nature of China’s exchange rate regime, however, China’s ability to control the relationship of the Yuan with both the Euro and the USD will be difficult, if not impossible.  The Bangkok Post reports:

Given the fact that about 70% of China's $1.4 trillion in foreign reserves are dollar-denominated assets and the majority of foreign trade transactions are cleared in US dollars, China has focused more on the RMB-dollar rate.

Read More: A tale of two currencies

ECB Still Mulling Rate Hike

At its last meeting, the European Central Bank (ECB) voted to maintain rates at current levels.  Nonetheless, inflation risks persist, and the ECB has not ruled out the possibility of hiking rates at its next meeting. At the same time, the Euro-zone economy is stalling, and the Bank has the onerous task of balancing these risks in trying to facilitate a "Goldilocks" economy. As a result, the ECB is in "information-gathering mode." Additionally, most of this information is publicly available economic data, and forex traders would be wise to do their own research, since the Euro-USD exchange rate outlook is tied closely to the monetary policy outlook. The Guardian Unlimited reports:

The ECB has said that slower growth in the 13-nation region would have an impact on its policy-relevant medium-term inflation outlook, and Gonzalez-Paramo said currency movements were one factor affecting growth.

Read More: ECB still in data-gathering mode

ECB to Hold Rates

The European Central Bank (ECB) will likely maintain its benchmark interest rate at 4.00% at its meeting his week.  The Bank of England is also expected to hold its lending rate in place, at 5.75%.  While these two moves should be seen by Dollar bulls as acts of clemency, they are more akin to a stay of execution than to a commutation of its death sentence.  The reasoning is that it is inevitable that the US-EU interest rate difference will be bridged over the next few months, as the Fed continues to lower rates while the ECB is in the process of hiking them.  The only question is when.  Accordingly, analysts will be paying close attention to the language employed by the heads of the various Central Banks at their next meetings to get a sense of timing.

Read More: Dollar hovers above lows

Europe Asks China to Revalue Yuan

Evidently frustrated by the Euro’s appreciation against the USD, a group of EU ministers has turned its attention to China, calling on it to allow the Yuan to appreciate against the Euro.  While the Yuan has appreciated nearly 10% against the USD over the last two years, it has actually decreased in value against the Euro.  As a result, the EU trade deficit has set a fresh record nearly every month. Unfortunately, the Yuan basically remains pegged to the USD, and since the USD is depreciating faster against the Euro than against the Chinese Yuan, the law of triangular arbitrage dictates the Euro must be appreciating against the Yuan.  It appears China’s hands are tied.  Bloomberg News reports:

“I can assure you China will continue to adopt a reform oriented policy on its exchange-rate mechanism,” said a Chinese Foreign Ministry spokesman. “But these adjustments have to be done gradually and in line with the market.”

Read More: EU Calls on China to Let Yuan Appreciate Against Euro

Euro sets another record

Euro sets another record Today, the Euro set another record, breaching the $1.40 mark.  While theoretically a meaningless achievement, $1.40 was an important psychological and technical barrier, since many traders place stop orders and limit orders at round numbers, such as $1.40.  Accordingly, upon surpassing $1.40, the Euro quickly accelerated upward, creating a short squeeze, where those who bet the Euro would not pass $1.40 were forced to buy to cover their positions. EU politicians have been surprisingly quiet as the Euro rose rapidly against the Dollar, commenting only that they would monitor the situation.  However, it seems inevitable that the value of the Euro will begin to play a more serious role in EU economic policy, since it is already beginning to hamper growth.  AFP News reports:

“Excessive volatility and disorderly movements in exchange rates is undesirable for economic growth,” European Central Bank president Jean-Claude Trichet said.

Read More: EU finance chiefs on guard over euro strength, market turmoil

Trade data supports Yuan appreciation

That the balance of trade between the US and China is becoming more and more lopsided in favor of China should come as no surprise to anyone.  In fact, economists yawned when the August trade data revealed a 33% jump in the Chinese trade surplus.  As a result, many are beginning to argue that China can allow the Yuan to appreciate at a faster pace against the Dollar, since it is obvious that China’s export sector will not be materially affected by a stronger Yuan.  In addition, China now exports more goods and services to the EU than to America, yet another statistic which supports the notion that China can allow its currency to appreciate against the Dollar (the implication here being that the Euro-Yuan exchange rate should be more important to China at this point).  Finally, China’s inflation rate is now hovering around 6.5%, its highest level in over a decade.  A more valuable Yuan would presumably make imports less expensive, thus lowering prices across the board for Chinese consumers. Bloomberg News reports:

The Chinese currency is selling for about 7.51 to the dollar. It has risen almost 6 percent against the U.S. currency in the past year while falling more than 3 percent against the euro, leaving the overall competitiveness of China's exports little changed.

Read More: Rising Euro Is What China Needs to Dump Dollar

Interest rate story buoys Euro

The Euro is closing in on the record high it achieved against the Dollar in July.  Once again, it is the interest rate story which is driving the currency skyward.  The continued rise of the collective economies of the EU is coinciding with a decline in the American economy, spurred by falling prices in the real estate and capital markets. As a result, economists are forecasting that this month’s respective central bank meetings will bring about a rate hike in the EU and a lowering of rates in the US. This prediction, which is also supported by the prices of interest rate futures, would narrow the EU-US interest rate differential to just 75 basis points!  Bloomberg News reports:

Traders also added to wagers the euro will strengthen against the U.S. dollar, figures from the Washington-based Commodity Futures Trading Commission showed on Sept. 7.

Read More: Euro Rises to Month-High Against Dollar on Growth, Rate Views

Dollar Holds Steady as World Awaits US Data Reports

Credit problems in the US have been the source of much turmoil throughout the global markets in the past few months. Tuesday was good for the US dollar, which held strong against both the yen and the euro. However, forthcoming economic reports from the US may or may not tip the scales. According to Reuters:

"The panic is almost over, but the market has lost its direction and is waiting for more news, especially any good news," said Kikuko Takeda, a currency strategist at Bank of Tokyo-Mitsubishi UFJ.

Read more: Dollar drifts as U.S. data awaited for direction

US Mortgage Troubles Now Affecting Euro

The US subprime mortgage and credit sectors are in dire straits, which has investors around the globe scrambling to save their money. From Europe to Asia, everyone is experiencing shockwaves. Now, the euro can be counted amongst the Australian dollar and British pound sterling as an increasingly weakening currency. According to Reuters:

The euro hit a six-week low versus the dollar and a four-month low against the yen on Tuesday on a Spanish press report that Santander (SAN.MC: Quote, Profile , Research) is facing $2.2 billion euro exposure to high-risk U.S. loans.

Read more: Euro falls as European exposure to US credit weighs

Euro’s Rise due to Optimism?

The Euro’s rise against the USD over the last year has been swift and unimpeded.  Many commentators have theorized that it is intense pessimism surrounding the US economy and economic conditions-namely the burgeoning twin deficits-that is responsible for the Dollar’s demise.  Now, a new theory is being batted around, one that is quickly gaining traction with analysts: perhaps it is optimism directed towards the EU economy rather than pessimism towards the US that is causing the Euro to spike.  After all, the European economy has rebounded nicely and boasts stable monetary and trade statistics.  However, this notion of European optimism, if it in fact exists, has some analysts worried that the markets are becoming too optimistic, and that if they are not careful, they will end up wrecking the European economy by driving up the Euro too high. The Times Online reports:

 

If the euro keeps rising without limit, Europe’s export industries will be decimated, as they were not only in Britain, but also in America in the mid-1980s and also in Japan after 1995.

 
Read More: The euro’s rise and rise is unsustainable

Norwegian Krone Rises on Rate Hike

The Norwegian Krone is certainly not a very popular currency among participants in the forex markets.  Nonetheless, the currency has enjoyed a strong year, having moved away from clinging to the coattails of the Euro and has actually surpassed the common currency by a considerable margin.  In fact, the Krone recently touched a 10-month high against the Euro, and a multi-year high against the USD, spurred on by a rate increase by the Central Bank of Norway.  In addition, the consensus among analysts is that the Central Bank will hike rates several more times over the next year, bringing the benchmark rate to 5.75% by 2008.  Surely, the most opportunistic among us has already begun searching for a broker that facilitates trading in Krone!

Read More: Norwegian krone jumps as central bank hikes interest rates

EU mulls currency “misalignment”

With the Euro handily outperforming the USD, Japanese Yen and certain other major currencies, many EU leaders have begun lamenting the impact they foresee on the EU economy. As most amateur economists are doubtlessly aware, however, there is a tradeoff between control over one’s currency and control over one’s domestic economy. In other words, if the EU acted in concert to hold down the value of the Euro, the ability of the European Central Bank to conduct monetary policy would be severely constrained. Accordingly, Jean-Calude Trichet, President of the ECB, is insisting that any efforts directed towards holding down the Euro be political, rather than economic in nature. Surprisingly, he is not opposed to EU political leaders holding talks with their Japanese and possibly American counterparts to discuss the growing perceived “misalignment” between the Euro and the Dollar. The Financial Times reports:

Mr Trichet had made it very clear in his comments to the European Parliament last week that there should be a dialogue between European countries and their partners over currency matters.

Read More: View of the day: Currency misalignment 

ECB, France at odds over Euro

The political furor surrounding the soaring Euro is reaching fever pitch, as European politicians clash with central bankers over the role of the state in determining exchange rates. Jean-Claude Trichet, President of the European Central bank (“ECB”) has argued that the Euro should be valued strictly by the markets. Politicians from EU-member states, on the other hand, have frequently argued that the surging Euro is hampering economic growth and should be used as a tool in economic policy-making. The newly-elected president of France, Nicolas Sarkozy, has been a vocal critic of the ECB, arguing that the Euro should actively be held down. The Financial Times reports:

In contrast to the US and Japan, where the finance ministry sets the exchange rate regime and intervenes in exchange markets, eurozone central banks hold and manage foreign exchange reserves and have responsibility for any market intervention.

Read More: ECB takes aim at Sarkozy over euro

ECB Defies Opposition and Hikes Rates

The European Central Bank (ECB) today raised the benchmark European lending rate to 4%, its highest level in six years.  The move came amid fierce opposition by European politicians who rightfully fear that higher interest rates will only send the Euro higher against other industrialized currencies and crimp the European economy.  The Euro is hovering around record levels against the USD, Japanese Yen, and Chinese Yuan, even though its economy is probably the weakest of the bunch.  However, the nature of the European Union means the interests of all member countries need to be looked after; while many of the traditional European powerhouse economies are struggling, Eastern Europe, for example, is thriving.  Taking matters into his own hand, France’s new president, Nicolas Sarkozy, is threatening to legislate a forced decline in the Euro, and many analysts think he may succeed.  The Telegraph reports:

“Sarkozy and Prodi are not going to let go of this. There's a groundswell of feeling that Europe is being taken for a ride by the rest of the world, and they're not going to put up with it any more.” 

Read More: ECB rates rise as gloves come off

Euro hovers near all-time high

The Euro is currently hovering above its all-time high against the USD, and is flirting with levels never-before-seen in the Euro’s brief, eight-year history.  The Euro had toyed with the record for the last couple of weeks, before finally breaching it upon last Friday’s release of US GDP data, which indicated the US economy had weakened to its slowest pace of growth in over four years. Investors are now waiting to see how the Fed responds to this latest development, as the bank has found itself in the unenviable position of navigating rising inflation and a slowing economy. Reuters reports:

Benign inflation data and modest growth in Midwest business activity provided more evidence of slowing U.S. economic growth, keeping sentiment bearish for the dollar, traders said.

Read More: Dollar stays near record low vs euro in quiet trade 

ECB cautions against Euro appreciation

“Pick your battles,” seems to be the mantra that Jean-Claude Trichet, President of the European Central Bank (“ECB”), is currently living by.  While the Euro is slowly inching closer to record levels against the USD, Trichet has largely been content to focus his energy on a different nagging currency: the Japanese Yen.  Trichet has invoked the phrase “two-way risks” in cautioning investors to beware the enormous potential upside of the Yen.  Trichet realizes that the Japan-EU interest rate differential, manifested through the carry trade, is responsible for the diverging Euro-Yen exchange rate.  Ultimately, it remains unclear whether the EU will continue to limit itself to rhetoric in the battle to hold down the Euro, or whether it will use more heavy-handed tactics.  Forbes reports:

“We believe the Japanese economy is on a sustainable path and that foreign exchange rates should reflect that,” Trichet said.

Read More: ECB's Trichet says currency markets should be aware of 'two-way risks'

EU Leaders to Discuss Euro Appreciation

As the Euro has gradually risen over the last year, EU leaders have been conspicuously silent.  Sure, generic comments had been made lamenting “volatility” in the forex markets.  But few politicians had made overt declarations that Euro’s appreciation was a matter that merited attention from EU member governments. This week, the silence was broken, as two notable politicians, the Prime Minister of Luxembourg and the Finance Minister of France, commented on the Euros’ appreciation, going so far as to discourage market participants from coaxing the Euro upward. IOL News reports:

“The markets should not embark on one-way bets.” Asked about the apparently resigned attitude of European countries…on exchange rates, Juncker [Luxembourg’s PM] hinted that there was more attention paid to the euro's strength than reflected in the final statement.

Read More: EU finance chiefs to focus on surge of euro

Euro reaches two-year high against USD

The demise of the USD continues, as the Euro rolls in the opposite direction, touching a two-year high against its American counterpart currency.  Analysts attribute the Euro’s sudden resurgence to the opposite directions that EU and US monetary policy appear to be headed.  In America, the question is no longer if rates will be lowered, but rather when they will be lowered.  Meanwhile, as Europe’s economy expands on the heels of export growth and strong industrial activity, prices are rising and the European Central Bank is talking about raising rates. Bloomberg News reports:

ECB President Jean-Claude Trichet said he wants to ensure price stability in the euro region. Interest-rate futures contracts show the ECB is likely to raise borrowing costs by a quarter-percentage point by September while the Fed makes cuts.

Read More: Euro Jumps to Two-Year High Versus Dollar on ECB Rate Outlook

ECB signals rate hike

At its monthly meeting to determine the region’s monetary policy, the European Central Bank decided to leave rates unchanged at 3.5%, but signaled that it would likely hike rates next month. The Bank’s president, Jean-Claude Trichet, who is an advocate of transparency, used his trademark phrase of “strong vigilance” to convey the Bank’s intentions to financial markets. The move will propel European rates ever closer to US rates, narrowing the differential which many believe is the only thing standing in the way of a long-term USD decline. However, European political pressure will likely prevent rates from being raised too high, as politicians fear an expensive Euro is hampering the EU economic recovery. The Financial Times reports:

Mr Trichet, who stressed the ECB’s independence, expected inflation to rise again this year and said that “the decisions we take today are to ensure price stability later on”.

Read More: ECB signals rate increase in March

ECB rate decision to drive Euro

The European Central Bank (ECB) is scheduled to meet tomorrow to mull the region’s monetary policy. With the Euo/USD exchange rate relatively unchanged over the last couple months, investors will be closely eying the ECB for signals about the direction of European interest rates over the coming months. The consensus is that the Bank will leave rates unchanged at the current meeting, but commentators have been quick to point out that inflation is slowly inching up, which could precipitate future hikes. Either way, Jean Claude Trichet, the notoriously transparent president of the Central Bank, will likely give investors a very clear picture of where he expects European interest rates will move in the near-term. DailyFX reports:

CB President Jean-Claude has been eager in the past to correctly steer market expectations, so if there is a chance of further hikes beyond March, the central bank will not want markets to totally dismiss the possibility of further moves.

Read More: Euro Price Action Contingent on ECB Decision, Commentary by Trichet

ECB rate decision to drive Euro

The European Central Bank (ECB) is scheduled to meet tomorrow to mull the region’s monetary policy. With the Euo/USD exchange rate relatively unchanged over the last couple months, investors will be closely eying the ECB for signals about the direction of European interest rates over the coming months. The consensus is that the Bank will leave rates unchanged at the current meeting, but commentators have been quick to point out that inflation is slowly inching up, which could precipitate future hikes. Either way, Jean Claude Trichet, the notoriously transparent president of the Central Bank, will likely give investors a very clear picture of where he expects European interest rates will move in the near-term. DailyFX reports:

CB President Jean-Claude has been eager in the past to correctly steer market expectations, so if there is a chance of further hikes beyond March, the central bank will not want markets to totally dismiss the possibility of further moves.

Read More: Euro Price Action Contingent on ECB Decision, Commentary by Trichet

Commentary: USD on its last legs

The USD has begun 2007 in neutral, idling against most of the world’s currencies, even gaining a few PIPS. However, this current period most likely represents a respite-rather than a reversal-from the USD’s long-term downward trend. The fundamentals behind the USD haven’t changed; if anything, they have worsened. Meanwhile, as the price of oil sinks back to sustainable levels and Central Banks move to diversify their reserves, governmental demand for USD-denominated assets may begin to stall.

The British Pound and Euro represent suitable alternatives to the USD. Both are strong currencies backed by political and monetary stability, as well as strengthening economies and rising interest rates. Risk-averse investors can already earn comparable returns from the side of the Atlantic opposite the US. In addition, as European capital markets expand and develop, foreign investors are discovering new assets to scoop up. Private equity and other forms of alternative investing are booming in Britain and the EU, which means even investors in search of risk have options in Europe.

Moreover, Asia and the Middle East are in early stages of developing regional currencies, which would also pose a threat to the dominance of the USD as the world’s reserve currency. As the global economy becomes more stable and as European and Asian capital markets surpass their American counterparts in size and clout, investors will no longer feel compelled to pool their wealth in American securities.

As former Treasury Secretary Robert Rubin recently noted, the only thing that is propping up the USD is that the demand for US assets (i.e. stocks and bonds) still exceeds supply. However, as equity prices approach levels never before seen and as the supply of bonds either dries up or yields are driven down to completely unattractive levels, the US will certainly lose its appeal to foreign investors and the USD will follow the foreign demand for US assets downward.

Relative EU exchange rates diverge

One technique for estimating the relative value of the Euro is to aggregate the value of all of the constituent EU currencies, using relative price movements as proxies for currencies. In Spain and Italy, for example, wages have skyrocketed over the past five years while productivity has lagged, which means these countries are relatively more expensive now. Germany, on the other hand, has been the economic leader of the EU, having benefited from declining real wages and surging productivity. When viewed as a sum of its parts rather than as a whole, Europe is plagued by many of the same economic problems that beset America, such as a negative balance of trade. A weighted average of European prices reveals a picture of what the Euro should be worth. Based on these three countries, it looks like the Euro is between fairly valued and overvalued. The Economist reports:

Spain now has the second-largest current-account deficit in the world in dollar terms. Germany's resurgence has set a challenge for the euro zone's southern members. Without the option of devaluation, their medium-term outlook looks less than rosy.

Read More: Beggar thy neighbor

Euro displaces Dollar in global capital markets

That the USD has remained the world’s de facto reserve currency has surely prevented the currency from declining significantly at a time when economic fundamentals seem to warrant it. However, the USD is slowly losing its luster as many of the world’s central banks have formally announced plans to diversify their foreign exchange holdings by holding more assets denominated in assets. As if that weren’t enough, a tally of global bond issues revealed that for the second consecutive year, more bonds were denominated in Euros than in USD. In addition, US stock exchanges accounted for just 15% of global equity offerings, down from 60% in 2000. The implications for foreign exchange markets are ominous: the role of the USD in global capital markets is diminishing, which is bad news for USD bulls. The Financial Times reports:

As recently as 2002, outstanding euro-denominated issuance represented just 27 per cent of the global pie, compared with 51 per cent for the dollar.

Read More: Euro displaces dollar in bond markets

ECB nervous over Euro appreciation

Jean Claude Trichet, president of the European Central Bank, is know for his terse, deliberately vague commentary. This week, he veered slightly away from that modus operandi by speaking out against Euro “volatility” in forex markets. In other words, he has not been delighted by the Euro’s rapid appreciation against the USD. While Trichet indicated that such an appreciation is bad for EU growth, he did not encourage EU governments to attempt to stabilize the currency. Thus, it is not clear how the markets will react to such comments, although if it appears likely that the ECB will alter its monetary policy as a result of the Euro volatility, the markets will certainly take notice. The International Herald Tribune reports:

ECB President Jean Claude Trichet said that while globalization had led to lower import costs for manufactured goods, it had boosted demand and increased oil prices.

Read More: ECB president says volatility in currency markets not good for long-term growth

ECB raises interest rates

The woes of the USD continued today, as the European Central Bank (ECB) raised its benchmark interest rate by 25 basis points, to 3.5%. The move was widely anticipated by economists, who predict two additional rate hikes in the spring will bring the ECB closer to the end of its tightening cycle and leave rates at 4%. Jean-Claude Trichet, president of the Central Bank, used GDP growth to justify the rate hikes and pointed to data that indicate the EU economy will grow by 2.9% this year, and by as much as 2.7% next year. While inflation does not loom as large as it did over the summer, the ECB is still clearly vigilant, which should be a cause of concern for Dollar bulls. Marketwatch reports:

Read More: European Central Bank lifts rates...

Euro to include more countries

The Euro common currency seems keen on inviting more countries to join. The only problem is that the EU has established prerequisites for membership that even current members would find difficult to satisfy. These terms are framed around stability, especially with regard to price, currency, the economy, and the budget. Slovenia and Estonia have satisfied the economic and currency requirements but are experiencing difficulty in managing their respective budget deficits and controlling inflation. Meanwhile, other countries, such as Sweden and Belgium, which are eligible for Euro membership, are having trouble garnering public support for the common currency. In short, it could be five years or more before the Euro expands to include more members. The Economist reports:

Westerners are starting to feel uncertain too. The Euro zone may already have too many misfits (Italy, for example, or Greece).

Read More: An Uncommon Current

French President dampens Euro

Why is it that every political leader thinks his nation’s currency is undervalued? South Korea, China, and Japan all actively engage in some form of currency manipulation. American politicians argue that the USD needs to depreciate in order to prevent the burgeoning trade deficit. Most recently, the president of France jumped on the bandwagon of forex intervention, arguing that Europe needed to take steps to hold down the value of its currency. He went so far as to challenge European political leaders to fight the efforts of the ECB to tighten monetary policy, which he sees as partially responsible for the Euro’s recent strength. However, opinions were mixed as to whether the Euro will suffer. The Financial Times reports:

[One analyst] was surprised at the zeal of the currency market’s reaction, given that there was little Mr Villepin could do about the strength of the euro other than lobby the ECB.

Read More: French PM sparks fall in euro

China pushes reserve diversification

Every month, almost like clockwork, when China announces its new total of foreign exchange reserves, a cloud of paranoia descends on currency markets, as traders weigh the likelihood of China diversifying its reserves. This month was different, however, as this paranoia seems to have been born out by Zhou XiaoChuan, chairman of China’s Central Bank. He stated explicitly that China would *continue* to diversify its reserves, but did not specify particular currencies or investments that would be targeted. However, the consensus is that any diversification by China, regardless of the scope, would surely benefit the Euro.

“Plainly, there’s a lot of sensitivity on this issue, and as an investor, one has to respect the market's reaction.”

Read More: China's reserve plans keep forex market on edge

ECB promises “strong vigilance”

At its monthly meeting held his week, the European Central Bank (ECB) left the benchmark Euro-zone lending rate unchanged at 3.25%. However, Jean-Claude Trichet, president of the ECB, announced that the ECB would exercise “strong vigilance” in monitoring economic conditions and weighing future rate hikes. While this kind of language could be confused as rather vague and generic, Trichet’s promise of “vigilance” has been used in the past to preface rate hikes. In addition, Trichet hinted that he would conform to the markets’ prediction that the ECB will raise rates in December. Meanwhile, the US economy is sputtering, and many economists expect the Fed to lower interest rates by a notch in the coming months, which could provide the impetus for the inevitable appreciation of the Euro. The Financial Times reports:

“We have a sneaking suspicion from the tone of the minutes that the ECB feels that it may well have at least a little more work to do in 2007 after December’s interest rate hike.”

Read More: ECB statement boosts the euro

Pound and Euro move in lockstep

In recent years, the British Pound and the Euro have begun to converge in value, so much so that both currencies have traded within 5% of each other for almost a year now. There are a couple of explanations for this trend. First, the relationship between the Pound and the Euro are largely symbolic. Perhaps, investors are grouping the two currencies together because of some perceived economic and/or political similarities. Second, it seems that all of the currencies that are supported by any semblance of sound economic fundamentals have risen against the USD, so it is possible that the Pound-Euro convergence is simply the result of both currencies simultaneously appreciating against the USD. Monetary policy and economic cycles are not aligned in Europe and Britain, so it doesn’t seem this link has any strong fundamental basis. Whatever the reason, in all aspects except for in name, the Pound has officially been absorbed into the Euro. The Financial Times reports:

From the euro’s launch in January 1999 until 2003, the pound initially traded in a wide 21.1 per cent range against the euro. Since then, volatility has been significantly reduced with the trading range falling to 8.6 per cent in 2004 and 7.1 in 2005.

Read More: Sterling in accord with the euro

How does public debt affect currencies?

By now, we all know that in the short run, interest rates and currency valuations are often correlated. In the long term, however, interest rate parity dictates that a country’s currency should move in the opposite direction as its domestic interest rates, in order to guarantee that investors in different countries receive comparable returns. This is consistent with financial economics, in that higher-yielding securities tend to elicit less demand, which means that the corresponding currencies sag due to insufficient capital inflows. Now, let’s apply this theory to the recent downgrade of Italy’s public debt. This downgrade will drive Italian interest rates higher as risk-averse investors flee Italy in search of safer investments. (Bond prices and interest rates move in opposite directions) The resulting capital outflows would cause the Italian currency (if it still existed) to depreciate. Fortunately for Italy, the capital outflows it suffers will be spread across the entire Euro-zone, and the net effect on the Euro will be negligible.

Read More: Euro shrugs off Italy downgrades

EU economy shows signs of life

When Jean-Claude Trichet, president of the European Central Bank (ECB), threatened “vigilance” against inflation last month, markets braced for what they believed would be several consecutive rate hikes. Recently, however, inflation seems to have largely disappeared, thanks to a leveling off of commodity prices. In the eyes of Euro bulls, this trend has been offset by a spate of positive economic indicators, which suggest the EU economy is as strong as it has been in over five years. Economists are now projecting growth of 2.5% for the EU area this year, with productivity increasing and unemployment declining. The result should be higher interest rates and a proportionately stronger Euro. The Economist reports:

In the long run, theory suggests that higher growth, other things equal, should mean higher interest rates for a given rate of inflation.

Read More: The euro area's economy

ECB lowers rate hike expectations

Since reaching a one-year high over the summer, the Euro has been punished in forex markets, due primarily to a less favorable outlook for ECB rate hikes. Previously, analysts were expecting the ECB to raise rates three to four more times, raising the base rate to 4%. Now, however, analysts have revised their models to reflect one to two rate hikes. Forecasts for the Euro have been adjusted proportionately to undo the narrowing of interest rate differentials that Euro appreciation had been predicated on. The Daily News reports:

Steve Pearson at HBOS said the scaling back in rate hike predictions is probably a reaction to the drop in oil prices which should in turn drag euro zone inflation well below the European Central Bank’s 2 pct target rate.

Read More: Euro continues lower as investors rethink ECB rate hike prospects

ECB rate hikes appear uncertain

Speculation has been building in forex markets over whether the European Central Bank (ECB) will raise interest rates at this week’s meeting. Previously, the consensus among traders was that the ECB would continue to tighten through the end of this year in order to keep pace with inflation. Since then, however, new data has been released, indicating that the European economies may have already peaked. Germany’s economy, for example, is now predicted to expand by less than 2% this year. Combined with moderating inflation, these new numbers indicate that another rate hike may not yet be needed. As a result, the narrowing interest rate differentials that USD bulls were fearing will not likely be realized for a few more months. Dow Jones News reports:

“There has been little indication that the central bank is prepared to step up the pace of its interest rate hikes and the likely timing for the next move is the meeting Oct. 5, with a further one in December leaving interest rates at 3.5% by year-end.”

Read More: ECB Unlikely To Hold Surprises For Euro

ECB to further tighten money supply

Last week, the European Central Bank raised interest rates to 3%. This move had been telegraphed to investors over the preceding few weeks, and the markets hardly stirred when the rate hike became official. Investors are much less certain about what the future will bring, but the consensus is the ECB will continue to hike rates. Growth is slowly picking up, and decreasing unemployment is removing slack from the labor markets. Meanwhile, Europe’s inflation rate, the indicator which the ECB openly uses a basis for conducting monetary policy, is hovering around 2.5%, which means the bank could certainly stand to raise rates further, to the tune of 50 or 100 basis points. Unfortunately for USD bulls, the ECB is beginning to tighten just as the Fed nears a peak in its interest rate cycle, which will make investing in the EU a more attractive option. The Economist reports:

The ECB has said for a while that the euro area's recovery is becoming more broadly based, shifting from exports towards domestic demand. If the American economy is slowing sharply, that is just as well.

Read More: Monetary policy in the euro area

Interest rates rise in Europe

The two most important Central Banks in Europe independently raised interest rates today. The European Central Bank (ECB) was first to announce a rate hike, in a move that was widely predicted by investors. The Central Bank of UK, however, caught most investors completely off guard when it announced a rate hike of its own. It appears to be a coincidence that both banks raised rates on the same day, as the economic policies of the UK and of Europe are not entirely related. The news made USD bulls nervous on two fronts: first, the narrowing of interest rate differentials means it is more attractive to move capital to Europe. Second, and less obvious, is the implication that growth is picking up in Europe, at the very moment it is slowing down in the US. The Financial Times reports:

Jean-Claude Trichet, ECB president… said that if the eurozone economy performed as the bank expected, “a progressive withdrawal of monetary accommodation will be warranted”.

Read More: ECB and UK join drive to raise rates

US Asset Inflows Weaken in April

A report released today showed that US portfolio inflows dropped sharply in April and were not enough to cover the trade deficit. This led to a decline in the USD's value agains the euro. The euro briefly hit its session high of $1.2658 before settling at $1.2615, up 0.1% from yesterday, at 1:00pm. According to Forbes:

"To the extent the private sector suddenly decided they didn't want U.S. securities that meant there were more dollars available on the foreign exchange market and that meant downward pressure on the dollar," Chris Probyn, chief economist with State Street Global Advisors in Boston, said.

Read more: Dollar slips vs euro on weak April US asset inflows

Dollar Continues Advance Near 5-Week High Versus Euro

As investors expect another rate hike by the Fed later this month, the US dollar came close to hitting its five-week high against the euro today. The Labor Department reported that US monthly wholesale prices were up 0.2% in May while the Commerce Department reported that retail sales rose by 0.1% in May. All of this has been in line with forecasts, thereby furthering the prediction that the Fed will raise interest rates soon. Forbes reports:

The upward shift in US interest rate expectations has helped the dollar, as has the general volatility engendered by this spike up. What has been bad for equities and commodities has benefited bonds and the dollar as they are considered to be less risky assets.

Read more: Dollar near 5-week euro highs on Fed rate hike expectations

USD Near One-Year Low Versus Euro

The US Dollar dropped to $0.7704 against the Euro earlier today, the lowest level since May 2005, before climbing back up to $0.7722 during midday trading in New York. The USD drop came after low U.S. employment data was released last week, thereby lowering expectations that the Fed would raise interest rates this month. Reuters reports:

Reflecting market expectations that the dollar's interest rate advantage is set to erode, currency speculators have increased their bets that the euro will appreciate against the dollar to record highs, data showed on Friday. "If you look at market positioning you can see that dollar bearish sentiment is pretty much growing across the board," said Naomi Fink, foreign exchange strategist at BNP Paribas in New York.

Read more: Dollar near 1-year low vs euro as key cenbanks eyed

Ifo Data Stronger than Expected

The latest Ifo survey released earlier today showed only a slight dip in German business expectations. The index dropped from its 15-year high 105.9 in April to 105.6 in May, much better than most had expected. While the Ifo may slip more in the coming months, a sharp dropoff is unlikely, as most believe the German economy should gain momentum later in the year. Forbes reports:

'The smaller than expected drop in the index will help the euro to sustain its gains and will do little to dissuade many in the market who look for the ECB to hike by 50 basis points next month,' said Mitul Kotecha.

Read more: Euro remains firm after strong Ifo data; market awaits US data

Euro Gains Support from OECD

Despite expectations of an interest rate hike by the ECB next month, the euro gained support as the OECD was only moderate in its calls for interest rate rises in the Eurozone. They said that the hikes should only be gradual and its chief economist Jean-Philippe Cotis said that the ECB should wait for second quarter GDP data before increasing rates further. The euro also gained support from Germany's deputy finance minister Thomas Mirow when he indicated that the German economy was unaffected by the euro's high level. Investors are currently awaiting tomorrow's release of the Ifo survey on German business expectations. It is expected that it may show only a slight dip despite the euro's high level.

Read more: Forex - Euro remains well-supported; market awaits German Ifo data tomorrow

ECB drives Euro to one-year high

The European Central Bank deserves full credit for the Euro’s breakthrough to a one-year high against the USD, yet it didn’t lift a finger. Rather, the ECB all but assured investors it would raise interest rates by 25 basis points to 2.75% in June. Jean-Claude Trichet, President of the ECB, joked with investors that they have been able to predict European monetary policy with reasonable accuracy. Trichet also commented the EU’s economic recovery, which is driving inflation and necessitating the interest rate hike. Reuters reports:

The [Euro] has climbed over 3 percent against the dollar in the past month to its highest level in almost a year and to a similar comparative level on a trade-weighted basis.

Read More: ECB steps up inflation warnings, signals June

USD plummets against Euro

Last year, the strength of the USD against the Euro came as a great surprise to currency traders and economists, alike, who believed it was only a matter f time before fundamental factors caught up with the dollar. In the last few months, however, the Euro has steadily climbed against the USD, all without much fanfare. This week, it crossed a psychological barrier and reached the milestone of 7-month high. The currency has been buoyed by strong economic indicators, notably German business confidence data. Marketwatch reports:

“The euro strengthened across the board as strong data and official comments contributed to expectations the ECB could ramp up its tightening path.”

Read More: Dollar low vs. euro, steadies on yen