EUR/USD 2006 Q4 Outlook
In the third quarter of 2006 volatility in the EUR/USD reached lows not seen since the launch of the single currency in 1999. The pair's range contracted to 450 points over the course of three months and over the last six weeks of the quarter ranges compressed to a mere 250 points.
EUR/USD Outlook
2006 Q3 - Volatility at Record Lows as Pair at a Standstill
In the third quarter of 2006 volatility in the EUR/USD reached lows not seen since the launch of the single currency in 1999. The pair's range contracted to 450 points over the course of three months and over the last six weeks of the quarter ranges compressed to a mere 250 points. While such price stability may have put smiles on the faces of central bankers it offered few profitable opportunities to traders as lack of momentum frustrated both bulls and bears. Part of the problem was the lack of an overarching theme as nether the neither US nor European Union policies provided clear directional signals to the market. In the US the Fed paused at 5.25% in August and while the rhetoric from most of the FOMC members continued to be hawkish, the US economic data in Q3 was decidedly dovish. GDP data printed at 2.6% versus 2.9% expected, Durable Goods declined in two out of the three months and both Manufacturing and Non-Manufacturing ISM surveys turned lower. In short the data indicated that at the very least the US economy was decelerating and at worst it was signaling a possible economic contraction all of which led traders to conclude that the Fed pause was in fact an end of the rate hike cycle. For its part the ECB continued to raise rates to 3.25% and hinted that it would increase them once again before year end by another 25bp. However, even with a move to 3.5% the Euro would continue to lag the dollar by 175 basis points putting it at substantial disadvantage on an interest rate differential comparison. Nevertheless, Euro-zone economy continued its recovery, though the pace of growth was steady rather than torrid with GDP increasing by 2.6%. Furthermore, inflation gauges contracted sharply receding from their 2.5% annual peaks set in July and putting into question the need for continued vigilance on the part of the ECB. No wonder then, that with so little transparency on either side of the Atlantic, the markets remained moribund throughout Q3.
Soft Landing or Hard Fall?
Perhaps the greatest question facing the market as we approach the end of 2006 is what will happen to the US economic growth? Will the US economy be able to absorb the marked decline in the housing market and maintain at least 2.5% GDP growth or will the contraction in demand finally tip the US into a recession. Certainly most recent data has shown s decrease in economic activity but has yet to signal a serious slowdown. Retail sales, especially autos have slowed as well, declining in two out of the three months in the quarter. However, while the data may appear discouraging it remains expansionary nevertheless. Both Manufacturing and Non Manufacturing ISM reports are well above the 50 boon/bust levels though off their highs and the latest retail data shows a strong rebound in spending. Sales were up 3.8 percent on a year-over-year basis in September, compared with an upwardly revised 3.8 percent pace in August, according to the report by the International Council of Shopping Centers. The group stated that, "September saw a dramatic shift in where consumers shopped. This was especially seen in the sales results of department stores which posted their best performance since January 1997. " With unemployment at historically low levels future economic prospects are likely to be determined more by wage growth rather than absolute number of new jobs. In this economic recovery wages have barely kept pace with the rise in inflation as consumers have augmented their spending with equity extraction from housing. As that option disappears for most US consumers due to a drop in housing values, income generation will become the critical determinant of the US consumers' ability to continue to spend and US economy's ability to continue to grow.
Housing Remains Key
With some analysts estimating that housing is directly and indirectly responsible for as much as 30% of US GDP growth over the past several years the health and stability of this sector remains vital to further US economic growth. Housing is clearly in a slowdown with Existing Home sales decreasing every month of the quarter. With deal flow slowing substantially in states like California where one in every 55 citizens is a real estate agent face dour prospects of massive job losses. However the true worry amongst most market analysts centers on present day home owners rather than future buyers. Fully one third of US mortgages or approximately $3 Trillion of face value of loans are comprised of adjustable rate or interest only payment instruments. As those mortgages are repriced in 2007 the fear amongst dollar bears is that they will cause massive defaults as monthly debt service burdens rise in some cases by a factor of three. However, things may not be as gloomy as dollar bears proclaim. The recent decline in US long term bonds may have unexpected positive ramification for US home owners. US Mortgage rates are greatly affected by US long term rates. With rates on 10 year bonds declining to 4.6% on Sept. 27 from a 2006 high of 5.22% on June 30, 2006 the 10-year Treasury note now yields less than it did in June 2004, when the Fed first began to raise short-term interest rates from 1%. Presently, the interest rate on a 30-year fixed mortgage is down to 6.25%. Although that's not as low as the sub-6% rates which were available in the middle of 2005, it is still considerably lower that the 6.8% rate on a 30-year mortgage prevailing as recently as July. Therefore a decline in mortgage rates may afford many of the ARM holders the opportunity to refinance their loans at lower rates and thus lock in manageable debt service payments all of which could stabilize the housing market, forestall any massive increase in foreclosures and greatly enhance the chances of a soft landing scenario.
Watch the Pump
One surprising source of support for the US economy has come form the gas pump Gas prices have declined materially from the $3.25 level only a few months ago to $2.25 presently, generating in effect a massive tax cut for the US consumer. By lowering the average transportation bill by $8-$10 per refill, lower gas prices have significantly increased discretionary income spurring additional spending by US consumers. Furthermore, recent problems at the Amaranth hedge fund which have led to massive liquidation of their long positions in natural gas have led to much lower prices in the underlying commodity. This in turn has provided another boon to the US consumer by lowering heating bills just as the winter season is about to start. With energy prices markedly lower, the US economy has received a welcome reprieve and should oil and natural gas remain at these lower levels throughout the fourth quarter they will serve as powerful counterweight to the bearish dynamics of the slowing housing market.
Eurozone Economy - Will VAT Kill The Recovery?
Unlike the US economy, the Eurozone economy has been decidedly stronger in Q3. Nothing reflected the strength of EZ economy better than the IFO survey which managed to remain near 5 year highs as both demand and employment in the 12 member region improved substantially. German unemployment rate for example declined to a decade low hitting 7.9% in July. This was a big improvement over the 9.6% level seen only 15 months earlier. Despite a rally in the currency against both the dollar and the yen, the Eurozone export sector which has been the primary driver of growth for the region has continued to expand smartly. In fact latest Factory Order readings jumped 14.6% on a year over year basis suggesting that the pace of economic growth is likely to accelerate into the end of the year. The one weak link in the EZ recovery story has been the consumer. Battered by four years of economic stagnation, the EZ consumer remains cautious. While French consumer spending has shown an uptake, Germany - the union's largest and most important member - remains a trouble spot. Latest German retail sales were flat after falling -0.8% the month prior while many market analysts are fearful of the impact of the increase in Value Added Taxes due to take effect in early 2007. German Value Added Taxes are expected to rise from 16% to 19% at the start of 2007 and up to now the center-right government of Angela Merkel has resisted any attempts to delay the tax hike, arguing that it is necessary to strengthen Germany's fiscal finances. The increase in VAT which translates to a whopping 19% jump in the cost of goods is services is likely to have a very depressive effect on consumer spending in 2007 which may short circuit ECB's attempt to tighten monetary policy much beyond the 3.25%- 3.50% level and may stifle the nascent recovery in the 12 member region.
ECB Hawkish But for How Long?
Throughout Q3 the European Central Bank has remained hawkish raising rates two times in three months to a current level of 3.25%. At its latest post announcement press conference the ECB President Jean Paul Trichet continued to reiterate the message of monetary tightening and price stability practically telegraphing to the markets that the ECB will go to 3.5% by December. The key question for the market however, is whether the central bank will take rates beyond that level. Certainly if energy costs remain at current relatively low levels inflation in the Euro-zone is unlikely to rise much above the ECB's self imposed 2% limit providing little reason to tighten further. Mr. Trichet however has also focused on the issue of liquidity in the Euro-zone banking system indicating that the ECB may choose to take rates higher to curb expanding liquidity even if inflation gauges moderate or fall. Generally, once Central Banks embark on a course they tend to purse their monetary policies much longer and further than markets anticipate. If the ECB follows this pattern EZ rates may reach 4% or higher by mid 2007 shrinking the interest rate differential between the Euro and the greenback to a negligible difference which in turn should prove to be Euro positive.
Reserve Diversification Continues
One final factor that continues to impact the exchange rate is the slow but steady program of reserve diversification by the world's central banks. Countries such as China, Russia, South Korea and India and the various Gulf states have been amassing enormous reservoirs of foreign exchange reserves. Russia's foreign reserves are presently growing at $20 Billion per month - dwarfing the pace of asset growth of any speculative player in the market. With the Euro as the only viable reserve alternative to the greenback the percentage of euros in these Central Banks portfolios has steadily increased. This trend has become especially pronounced in countries such as Russia which does the majority of its trade with the Euro-zone and China which now exports more good, to Europe than to United States. This movement towards more Euro diversification may accelerate as the exchange rate nears the 1.2500 level which appears to be the preferable price point of many Central bank purchases. Furthermore, if the sharp deterioration in US Balance Sheet position continues as TICS capital inflows print materially lower than the ever widening Trade deficits, the whole dynamic could quickly pick up pace and cascade as speculative traders begin to join the Central bankers in stockpiling euros.
Conclusion
US soft landing or the onset of a recession? Continued Euro-zone growth or the end of the recovery as VAT goes into effect? Massive increase in diversification into euros or a steady flow into well performing US capital assets? The questions facing currency traders as we approach the end of 2007 are myriad and complex offering little transparency. The market confusion is reflected in the price action which has shown some of the lowest historical volatility ever. At present the preponderance of fundamental evidence points to greater risks for the dollar rather than the Euro. But markets have a way of surprising participants. Lower energy costs, a milder winter and steady improvement in wages could fuel a renaissance in US consumer spending that would significantly alter the US growth scenarios for 2007. Amidst this unclear market environment one thing is certain. As surely day follows night volatility expands after periods of compression. Thus while the direction of the pair may difficult to forecast as the new year approaches, the amplitude of the move is likely to be large.
Technical Outlook
The 5 month EURUSD consolidation between 1.2976 and 1.2456 has lulled market participants to sleep. However, periods of low volatility are followed by breakouts so now is the time to keep an eye on price action. Bollinger band width indicates the extent to which volatility has contracted (as of 10/5). It is interesting to note that this is the tightest the bands have ever been for EURUSD (since the advent of the Euro in 1999). Going back 10 years with synthetic prices, there is only one instance when volatility was this low (according to BB width) - August 1998. BB width reached a low on 8/12/1998 and the breakout occurred two weeks later. 2 months later the pair was 1,500 pips higher. Technically, the larger picture appears tilted to the downside due to both wave count and the nearly two and a half year head and shoulders reversal pattern as seen in the chart below. A larger degree wave count points to a pending wave C (3rd wave of the correction of strength to 1.3666) decline that in coming years could fall as low as 1.1000 (where wave A would equal wave C if 1.2976 holds as resistance - (1.2676 - (1.3666-1.1640) = 1.0950). Further, the 50% fibo of the .8225-1.3666 October 2000 to December 2004 rally is at 1.0946. Weekly oscillators such as RSI are sloping down after forming slight negative divergence and thus favor the larger bearish outlook. Projecting a trendline from the 1.3666 and 1.2976 highs and placing the parallel line at the 1.1864 and 1.1640 lows suggests the possibility of a 1.1000 low near the end of May 2007, but of course the critical support of 1.2456, which is the 7/19 low would first need to be broken followed by the head and shoulders neckline at approximately 1.1640. The decline from 1.3666 to 1.1640 was 47 weeks in length and the rally from 1.1640 to 1.2976 was 30 weeks in length (30/47 = 63.8% - very close to being a perfect 61.8% in regards to time). The week ending May 25, 2007 would be 50 weeks from the week that produced the 1.2976 high (6/9/2006) which would end up as a 1-.618-1 ratio in regards to time for the 3 corrective waves of the rally to 1.3666. However, a rally beyond 1.2976 would weaken that scenario by opening the door for a larger move to either the 4/21/05 high at 1.3123 or the 78.6% fibo of 1.3666-1.1640 at 1.3232.
EUR/USD Positioning
Speculative positioning is correct for the meat of the trend but the herding nature of market participants eventually leads to a 'bubble' and a top (or bottom). In other words, extreme positioning inevitably leads to a correction / reversal. IMM futures data indicates that speculative Euro longs topped out on 8/11. Notice that the previous record for Euro longs preceded the 2005 decline in EURUSD.
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