Highlights

  • Credit market crisis continues to weigh on the dollar
  • Monetary policies in the US and Europe are diverging further
  • Verbal intervention is having little effect so far

Dollar weakness fuels euro’s rally

EUR-USD seems to be moving in one direction only. The euro leapt to a fresh high of 1.4752 this week, and ended the week only slightly below this. The greenback also lost ground against other major currencies such as the yen, the pound, and the Australian dollar, in some cases dropping to levels not seen for many years. Worries that the credit crisis could worsen were the main cause of the dollar’s latest bout of weakness. Large US banks announced further significant write-offs on mortgage-backed securities. Moreover, the vicepresident of the National People’s Congress surprised markets by saying that China would favour stronger currencies over weaker ones when investing its immense foreign currency reserves. This fuelled the debate on the dollar’s role as the leading reserve currency, putting the dollar under renewed intense selling pressure.

Forex dealers are mainly concerned about the ripple effects of the credit crisis. No sooner had the US central bank attempted to adopt a “wait and see” stance after the last 25 bp interest rate cut, than market participants had reverted to expecting a further rate cut on 11 December in the wake of more bad news from the US banking sector. This impression was not allayed by Fed chairman Ben Bernanke’s testimony before the US Congress Joint Economic Committee. He is expecting US growth to slow down noticeably in the coming months as a result of the credit crisis, and predicts that growth will continue to be weak in the first half of next year. Mr Bernanke is not expecting growth to accelerate until the second half of next year, and then only slightly. However, the fact that the high oil price could dampen growth even more, is posing a risk to this outlook. The Fed chairman emphasized the significant upside risks to inflation given the high commodity prices and the weak currency, but market participants are hardly taking any heed of these dangers at the moment. They are rather expecting the Fed to cushion the economic slowdown by cutting interest rates further.

Thus monetary policies in the US and Europe are likely to diverge even further and this could weigh on the dollar. Both the Bank of England and the European Central Bank kept interest rates on hold this week, as expected. As inflation rates are high in the eurozone, and will probably rise even higher by the beginning of next year, the prospects of an interest rate turnaround in the euro area have deteriorated markedly. In its rhetoric, the ECB is still signalling that it is prepared to act. However, as it is sees rising inflation rates as a temporary phenomenon, which should not have an impact on inflation expectations, further interest rate increases are unlikely in the coming months, given the downside risks to growth.

Eurozone growth data due to be published next week are not likely to change this either. They will probably confirm the ECB Council’s fairly optimistic economic assessment. Jean-Claude Trichet indicated that the ECB Council sees no reason to alter its base scenario of sustained robust growth for the eurozone. In our view, the growth rate will be close to potential in Q3.

The euro’s rally could be hampered by politics next week. Jean-Claude Trichet has already pointed out that “brutal” exchange rate movements are never welcome. In 2004, such utterances halted the soaring euro, but this time, they do not appear to be having much effect on forex market players. Similar warnings are likely to be issued by the Ecofin Council at the beginning of the week, and the G20 finance ministers at the end of the week. However, these verbal interventions are unlikely to be followed by any concrete monetary policy actions.