Currency markets can be moody. Immediately after the release of the weak US labour market report last Friday, EUR-USD rose by 1.5 cents to over 1.33. But after the Open Market Committee decided that, given the disappointing economic recovery, the proceeds from maturing agency bonds and mortgage-backed securities held by the Fed should be used to purchase additional Treasury bonds, the euro began to lose ground.
On Thursday, EUR-USD dropped below 1.28, and was around this level towards the end of the week. USD-JPY fell to a 15-year low of 84.73 initially, but then recovered to just under 86.
The movement in the currency market shows a return to the familiar pattern seen during the financial crisis: once again, bad news from the US prompted a widespread flight from risky assets (equities, commodities, credit products) back into safe havens. Government bonds and gold are much in demand. In the forex market, the dollar and the yen benefit particularly from crisis fears.
Oddly enough, it was the FOMC meeting and not the labour market data, that sparked these market reactions, even though, after the release of the US labour market report, it had been widely expected that the Fed would take action.
The measure taken by the US central bank is not at all aggressive, quite the contrary in fact. The Fed is only using principal payments to purchase 2 to 10-year US Treasuries, thus keeping the balance sheet at $2054bn. Monetary policy is not becoming more expansionary, but remains as expansionary as it was before. Real concern about a double dip or a deflationary scenario would have prompted a different reaction.
Furthermore, the amounts concerned are relatively modest: in spring, the New York Fed had estimated the total volume of bonds due to mature by the end of 2011, or already paid back prior to maturity, at “at least $200bn”. For the first month (mid-August to mid-September) the central bank is envisaging reinvesting $18bn. In relation to the Fed’s balance sheet and public net borrowing, which are set to reach well over $1000bn in 2010 and 2011 respectively, the reinvestments seem almost puny.
The hefty market reaction might have been triggered by the rather pessimistic outlook of the Bank of England in its latest inflation report and slightly worse-than-expected economic data from China, suggesting that the growth outlook for Europe (and the rest of the world) might not be as rosy as originally predicted. This, combined with heightening fears of deflation in the US, probably tipped sentiment in the markets. In view of the previous gains of the euro and other European currencies against the dollar and on equity markets, market participants decided to take profits.
In our view, the growth concerns are still exaggerated. Although economic momentum in the US is now slacker than in earlier recovery phases, the economy is still expanding. Current consensus estimates are forecasting growth rates of just under 3% for 2010/11, the Fed’s forecasts were significantly higher in July. Final domestic sales rose markedly in Q2 for the first time, both ISM indices are still showing an increase in economic activity, and, according to the quarterly reports, most companies see their business outlook as positive. We therefore see no reason to throw in the towel.
The European data give no cause whatsoever for undue scepticism. The Q2 growth figures, which have just been released, show that GDP in the eurozone rose by 1.0% quarter-on-quarter.
Growth was largely driven by Germany, where, according to preliminary figures, GDP grew by a stupendous 2.2% compared to the previous quarter. This, together with solid figures from France, the Netherlands and Belgium, more than compensated for the weak results in the southern eurozone countries, where growth was curbed by fiscal austerity measures. Thus overall, there has been an improvement in production capacity utilisation. And the leading indicators as well as anecdotal evidence from companies do not suggest a setback.
Against this backdrop, we are inclined to regard the euro’s current weakness against the dollar as a correction. In the longer term, we still see the euro above 1.30. Market participants should keep a close watch on US economic data in particular.
They should also bear in mind that money market rates in the eurozone will probably continue to rise in the coming months and that a strong dollar is hardly in the interests of the US economy.
