Euro seen breaking support, might easily dip to 1.0680

Outlook:

This is going to be a big week. At the end of it, we have the start of the Easter holiday on Friday, with some markets closing early, officially or not. Markets are closed on Friday and Monday in some European countries. Friday also brings the start of Passover. Before sun-down, we get payrolls. And before that, on April 1 the Tankan is published. Sentiment is messy and divided in Japan—the Tankan could be decisive.

Today we get Feb personal income and consumption, plus the core PCE deflator, the Fed’s favorite, or it used to be. Expectations are for income to be up 0.3% in Feb, the same as Dec and Jan, but with a rise in consumption by 0.2%. The core deflator will probably be the same 1.3% y/y. Later this week we get pending home sales and auto sales. Tomorrow we get Canadian GDP, with any pullback likely to start up talk of BoC “insurance.” A week from tomorrow, the RBA meets, with expectations running rather high of a cut.

The Fed is not going to get forgotten in all this flood of new data, On Friday, Yellen said “Like most of my [Fed] colleagues, I believe the appropriate time has not yet arrived, but I expect that conditions may warrant an increase in the federal funds target sometime this year.” She named a number of reasons for caution. As for what would delay the first rate hike, none of the reasons included other markets, international conditions, or anybody else’s economy or central bank.

Market News notes Out of 4292 words in Fed Chair Yellen's speech Friday, she referred to the "dollar" twice. "Of course, not all sectors of the economy are doing as well: dollar appreciation appears to be restraining net exports, low oil prices are prompting a cutback in drilling activity, and the recovery in residential construction remains subdued," Yellen said. Later in the speech, she said, "Although the re-cent appreciation of the dollar is likely to weigh on U.S. exports over time, I nonetheless anticipate further diminution of the headwinds just noted over the next couple of years, and as the equilibrium real funds rate continues to rise, it will accordingly be appropriate to raise the actual level of the real federal funds rate in tandem, all else being equal."

Ceteris paribus—all other things being equal. When you hear an economist utter those words, run for the hills. With any luck, Vice Chair Fischer will be more straight-talking this evening at the Fed of Atlanta Annual Financial Markets Conference. The problem is that while it’s perfectly reasonable for the Fed to want to wait for data clarity, it’s of no use at all to financial managers trying to plan their allocations. And judging from the 10-year yield at under 2%, the fixed income crowd is deeply dissatisfied. When in doubt, do nothing.

As for the dollar, we are about to get a flood of commentary on tomorrow’s IMF quarterly reviews of reserve holdings. The COFER report (Currency Composition of Official Foreign Exchange Reserves) will likely show a massive flow into dollars and out of euros. The WSJ cites a Citicorp study that shows “In the past eight months, the dollar has risen more rapidly than at any time in the past 40 years when compared with the currencies of its major trading partners… The dollar has risen 28% against the euro since May and the WSJ Dollar Index is up 19% over the past year.” The last release in Dec already had the euro’s share of reserves fall 1.5% to 22.6%, the most since 2004. This time it could be a lot worse. As analysts note, the dollar may be overvalued, but negative returns are, well, negative. Of course re-serve money is flowing out of euros.

This brings up the age-old question of the inherently unfair system of the top reserve currency having “inordinate privilege,” as the French complained in the early 1970’s. The reserve currency country has involuntary demand for its currency and as a result can borrow more cheaply than any other sovereign. Well, okay, but the reserve currency issuer is also the military superpower of its day and the country with the most vibrant and stable economy. In the case of the UK and US, which is the model we have for the past century or two, the power and the economic robustness arise from the rule of law, the sacred role of personal property, the rights of individuals over the rights of the state, free markets, and all those other things we learned about in high school.

Those who say the eurozone or China are going to eat the US’ breakfast on the reserve front at some point in the next few decades had better go back and examine the very real conditions that make a re-serve currency valid. We wrote not one but two chapters about this in The FX Matrix (with Vicki Schmelzer at Market News). It’s important to note that the eurozone has one tremendous advantage—its primary goal is to defeat and control inflation, and no sovereign has ever made that promise before. The eurozone gets away with a lot because it has that unique feature. But the eurozone also has tremendous frictions—over regulation, labor laws and the job markets, preference for protecting financial institutions over citizens (which is why Europeans rely on banks and have a small, fragmented and weak private bond market). And China—well, China is a communist state. Sometimes we forget that, since the Chinese understand markets better than anyone. Communists often do. But financial markets in China are not free. They are engineered and managed.

So, when the commentators start up about the overvalued, overbought dollar, let’s not forget that there is the reserve currency context. Surely it subtracts some of the overvaluation.

As for the immediate future, we see the euro is breaking support and can easily dip to 1.0680 or so, the 62% retracement. It may bounce from there (or not). But we don’t see the euro making gains if this morning’s relatively good data—green shoots—failed to give it a boost.