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2006 Marked Significant Divergence between the EU and US

Friday, 22 December 2006 16:28:28 GMT  |  DailyFx Research Team

EUR/USD Outlook

Divergent Growth/Divergent Rates

2006 was marked by significant divergence between the Eurozone and United States in both economic growth and interest rate direction. While US GDP growth dropped markedly from a high of 5.6% in Q1 of 2006 to 2.0% in Q3, Eurozone economic performance headed in the opposite direction rising steadily from 2.2% at the start of the year to reach 2.7% by Q3.

In fact, Euro-zone growth exceeded US GDP growth on a quarterly basis for the first time in four years.  The story was similar with respect to monetary policy. After 18 consecutive rate hikes, the Fed finally paused in August keeping US short term rates on hold for the past 6 months. The ECB on the other hand has remained resolutely hawkish, raising rates consistently throughout the year from 2.25% to 3.50%. The net effect of these divergent monetary policies was the compression in interest rate differentials between the euro and dollar from a 225 basis point spread at the start of the year to 175 basis points by the end of 2006.

Can European growth and interest rate policies continued to decouple from US in 2007? The latest data suggests that could indeed be the case.  Despite the significant appreciation in the currency, the European export sector has shown remarkable resiliency as the region’s Trade Balance registered a better than expected surplus of 2.4 Billion euro in October.  Furthermore the reading of the influential IFO survey recorded its highest value in 15 years as German business confidence improved not only in the near term but also in the intermediate time frame. Additionally the ECB has not eased away its hawkish stance with several members including Axel Weber and Yves Mersch insisting that interest rates are still low. This combination of factors could mean that the ECB may not be finished with its tightening campaign and could well push rates to the 4.0% level in 2007. On the flip side, the Fed faced with a deteriorating demand in the housing sector and as slowdown in manufacturing is unlikely to initiate any additional rate hikes for the foreseeable future. Latest results from the ISM manufacturing survey showed a drop to 49.5 – the first plunge below the 50 boom/bust level since April of 2003. While manufacturing comprises a far smaller percentage of US GDP than services, the sector is nevertheless important to the overall fabric of the US economy because of it’s concentration of higher wage jobs and flow through impact to the rest of the US economy. Therefore until and unless the manufacturing sector shows signs of revival, the Fed is likely to be sidelined while the ECB may tighten further.

It’s all About the Consumer

With 75% of the US economy driven by consumption, consumer spending remains the critical lynchpin for the US dollar.  In the second half of 2006 US consumption was hobbled by the twin specters of declining house values and rising energy costs. Housing values receded markedly from their peaks set in 2005 offering less of an opportunity for consumers to refinance their mortgages. Mortgage Equity Extraction (MEW) acted as a major source of funds for US consumers during 2004 and 2005 but its power began to wane in 2006 and will likely provide even less stimulation for the US economy in 2007 as housing values continue to contract. Additionally persistently high energy costs have started to put a heavy burden on the lower end of the consumer market as evidenced by stagnation of sales in Walmart which has produced results near the bottom of its guidance parameters over the past two months. At the same time Retail Sales in the Eurozone have also been lackluster as they missed market expectations the last three months in row. Although the Eurozone economy has clearly perked up, the consumer has not yet abandoned his recessionary mindset. Many analysts thought that the advent of the World Cup would stimulate consumption for the Eurozone, but while sales did pick up during the 4 week spectacle, the region’s consumers reverted right back to their frugal ways once the event was over. The situation may be further aggravated by the prospects of a major hike in the German Value Added Tax due to take effect in early 2007. The increase from 16% to 19% is likely to dampen spending even more and possibly curtailing the nascent EZ economic recovery. Meantime in the US, future retail sales could receive a boost from additional wage gains. Wages have grown at 4.1% annual rate – their best performance this decade. Should that trend continue, the rise in wage income may offset some of the more negative effects of lower housing and higher energy. Therefore, consumers in both US and the Eurozone – two of the world’s largest markets – remain at a crossroads each facing unique challenges in 2007. How they respond to them may well determine the course of growth in each region and the ultimate direction in the EURUSD.

US Capital Inflows – Still Positive?

Record US Trade deficits and Current Account deficits which are presently within a whisker of reaching $1 trillion per year have generated panicky headlines in mainstream media about the long term viability of US Balance sheet position. Indeed looking at the problem strictly from the standpoint of US liabilities suggests the possibility of a major decline in the greenback. However, the US not only runs the biggest trade deficit but also enjoys the largest capital surplus in the world attracting the vast majority of foreign funds into its fixed income and equity markets. Although in 2006 currency markets were abuzz with talk of Central bank diversification from dollars to euros,  the latest data from the International Bank of Settlements suggested that Asian and Persian Gulf central banks which are the primarily earners of excess capital continued to hold the vast majority of their reserves in US dollars. Indeed, the latest Treasury Inflow Capital Securities data showed a comfortable surplus of $82.3 Billion against a shrinking Trade deficit of -$58 Billion. As long as TICS surpluses continue to cover US Trade deficits, the threat to the dollar will be more imagined than real.

However, China which presently holds more that $1 Trillion dollars in FX reserves, remains a critical contributor to dollar stability going forward. A newly elected Democratic Congress and more belligerent attitude from Fed Chairman Ben Bernanke, who in a recent speech in China suggested that the country’s currency policy resulted in an effective export subsidy, could spur a diplomatic as well as a financial conflict with one of the US’s largest trading partners.  Should China simply stop purchasing new US government and agency debt obligations, the safety margin between the TICS surpluses and the trade deficits could narrow dangerously and reignite worries about future US financing capability.  Therefore, the US China relationship may well be the single most important geo-political factor facing the US dollar next year. As long as Chinese and Persian Gulf countries continue to recycle their surplus dollars into US securities – a process some analysts have dubbed “Bretton Woods II” - the dynamic should generate global growth and relative stability in the currency market. However, if this process is somehow compromised for political reasons the greenback could face serious turbulence in the year ahead.

EZ Political Risk Reduced But Not Entirely Gone

Meanwhile, while the dollar faces a multitude of problems, the euro has worries of its own, The unit remains a currency without a country and while memories of 2004 failure to ratify the EU constitution have receded from most traders memories, political turmoil in the region rests just beneath the surface. The conflict between the frugal and prosperous north led primarily by Germany and the profligate and less developed south continues in the Eurozone. Italy is the epicenter of this fight. As the perpetual sick man of Europe it struggles with its antiquated industrial infrastructure and weak political leadership. The center left government of Romano Prodi has already felt the wrath of labor unrest as the street of Rome were left strewn with garbage for weeks on end. Faced with a staggering government debt of 106% of GDP, Italy remains vulnerable to further political instability especially if growth begins to slow. 

Additionally France is in the midst of political change as well, as the country looks to new election in April of 2007. Presently the center left Socialist leader Segolene Royal who could become the first woman President of France is leading her center right opponent Nicholas Sarkozy. Most currency analysts view Ms. Royal as somewhat of an economic reformer and therefore ultimately positive for the euro. However, should electoral politics force her to take a much more protectionist stance, the markets may react quite negatively to any political pressure that she may exert.
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Finally the integration of eastern Europe with far lower GDP/per capita and much lower wages remains the biggest challenge for the region.  Slovenia is the first East European nation to enter the full union this year and while country itself is small the market will watch it carefully as a test case for much larger nations such as Poland and Hungary.

Fortunately, the latest economic data suggests that the economic recovery in the region continues to gather pace. Even Italy is seeing concrete benefits of the pick up in growth as its unemployment rates shrink below 7% - the lowest reading in more than 15 years.

In short, the euro has made tremendous strides in terms of credibility as a viable alternative reserve currency, but the Continent’s problems of fractional nationalism have not completely disappeared. If the ECB goes too far in its monetary tightening campaign, suddenly bringing growth in the region to a halt, the long buried conflicts may rise to the surface and the outcries from the politicians of various member countries may well exacerbate the situation and damaging the currency further.

Conclusion

As the currency market looks ahead to 2007, the outlook for the EURUSD remains cloudy albeit present developments are favoring the euro. The currency pair’s potential strength lies in further compression interest rate differentials between ECB and the Fed as the latter remains sidelined due to a considerable slowdown in US economic growth while the former maintains its hawkish stance supported by a steady pick in growth and improving labor markets. Should this decoupling of economic fortunes between the Eurozone and the US continue, the euro could clearly rally further and even challenge the all time highs in the pair set in 2004 at 1.3643.  However, the Eurozone itself is not trouble free. The prospects of a 30% hike in the Value Added Tax (VAT) in Germany, new elections in France and perpetual political instability in Italy could derail the regions’ strongest economic expansion this decade. Finally, the deteriorating state of US–China relations could threaten the delicate balance between global trade and capital flows. In short, while low volatility in 2006 lulled many FX participants into a state of complacency, 2007 has the potential for much larger swings in price action as these key macro economic themes play out on global stage. 

Technical Outlook

The 5 month EURUSD consolidation between 1.2976 and 1.2456 that has lulled market participants to sleep led to the much anticipated breakout above 1.3000.  Strength extended to 1.3367 in what may have been the end of a 5 wave bullish sequence that began over one year ago at 1.1640.  Expectations then are for a 3 wave correction lower to fibo support that begins at the 38.2% of 1.1640-1.3367 at 1.2709.  A long term supporting trendline drawn off of the 2002 and 2005 lows intersects with this Fibonacci level in late March.  A price distance of about 400 pips in 4 months is not much, but it fits with the idea of a corrective move lower (rather than an impulsive one).  A break below the long term trendline (in red) exposes additional Fibonacci support at 1.2506 (50% of 1.1640-1.3367) and 1.2303 (61.8% of 1.1640-1.3367).  If 1.3367 is exceeded, then focus shifts to the 3/18/2005 high at 1.3477.   

EUR/USD Weekly Chart (Source: FXTrek Intellicharts)

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