Half Year Outlook of EUR/USD

In the middle of April, the EUR/USD broke out to the upside and began to climb, hitting a high of 1.2980 in early June. The Euro gained strength primarily on US dollar weakness as traders began to look for an end to the US Federal Reserve's tightening cycle. However, the Fed has continued to test the resolve of the market by tightening for longer and further than most analysts had expected. At the beginning of the year, US Fed funds rates were 4.25 percent, leading many to argue that 4.75 or 5 percent would be the top in rates. We are now at 5.25 percent and despite less hawkish comments from Fed Chairman Bernanke at his semi-annual testimony on the economy, a large portion of market participants still believe that he may raise rates again this year. Inflation has become such a grave concern for the Federal Reserve that they are increasingly willing to risk the possibility of a recession in the US economy at the expense of taming inflation. Which comes first will help to decide the fate of the US dollar in the second half of the year. In the meantime, Eurozone interest rates are on the rise. As the Federal Reserve inches closer to ending their rate hikes, the European Central Bank continues to remain extremely hawkish. Taking their time, the ECB has been conservative with their rate hikes in the first half of the year, but in the second half of the year, they are expected to be much more aggressive. The central bank has turned what typically is an administrative conference call meeting in the first week of August into a full fledged monetary policy meeting with a press conference afterwards, sending an extremely strong signal that they plan on raising rates in the beginning of the month with one or two more hikes to possibly follow in the second half of the year.

Will the Fed Stop at 5.50% or 6%?

Before the ECB and Euro can drive the trend in the market, the Federal Reserve has to first hand off the reins. In 2005, the Fed was the primary central bank to aggressively raise interest rates which led to a strong dollar rally. In the first half of 2006, the Fed continued to raise rates, but the ECB joined in the party and a new trend was emerging. The market was searching for an end point from the Fed and a beginning point from the ECB. This divergence prompted the EUR/USD to rally from 1.18 to a high of 1.2980 before settling back down to 1.25. The persistence of Fed pushed the end point further and further out and to date, the market is still searching for an end. Whether the Fed chooses to bring rates to 5.50 percent or 6 percent will be primarily dependent upon inflation. As a new central banker, Bernanke wants to prove that he can be an inflation fighter. Even in the clear midst of weakening economic data from the labor market, housing market and consumer spending, Bernanke has stood strong on his goal of maintaining price stability. Many have wondered whether he is playing with fire. The yield curve has inverted significantly signaling that that a sharp slowdown is expected in 2007, if not earlier. How far he decides to take things will depend on what happens first - a spike in inflation or a sharp contraction in growth. Once the curtain is dropped, US fundamentals will be the most important and at the present moment, they call for more dollar weakness than strength.

Housing Still a Big Risk

Housing is still the real wildcard. The real estate market is slowing with inventories building, prices and existing home sales falling and builder confidence slipping. Even though new home sales ticked higher in the month of May, deep discounts and upgrades by builders are spurring the sales of new developments. A better reflection of what may be to come can be found in the NAHB survey of home builder confidence. In the month of July, confidence fell for the sixth consecutive month to the lowest level in 14 years. The higher the Federal Reserve brings interest rates, the more risk it poses for the housing market. With the US savings rate having fallen below zero, indicating that Americans are spending more than they are earning, we know that much of that spending has probably been fueled by borrowing. This is a behavior that cannot be sustained for long, especially as Americans are faced with increases in the cost of living. Mortgage rates are on the rise at the same time that energy prices are climbing. Oil acts as a tax for consumers and with record high temperatures in the US, consumers may be forced to cut their discretionary spending in order to pay their air conditioning bills. Of course, many people have been calling for a burst of the housing market bubble for years now and have been proven wrong repeatedly. Yet the mania is getting more and more dangerous with mounting evidence that the day of reckoning may be right around the corner. When that happens, the Fed will be forced to cut short their tightening policy, which will have strongly bearish implications for the US dollar.

Hot Spots around the World are Igniting

In the first half of the year we were worried about Iran. In the second half, we are worried about Iran, North Korea and the tensions between Israel and Lebanon. Hot spots around the world are igniting and the US dollar has been the primary beneficiary of risk aversion. The relative safety of the US, its geographical distance from the turmoil and the country's high interest rates has made the dollar an attractive place to hide. Oil prices have also retraced because the latest escalation of conflict has not been in oil producing countries even though Iran has been reported to be involved in the Middle East conflict to some degree. If Iran stirs trouble once again and oil prices resume its rise, the attractiveness of the US dollar as a risk averse investment may decline.

Eurozone Economy - Can Strength be Sustained?

Unlike the US economy, the strength in the Eurozone economy has been much clearer. Led by Germany, the World Cup effect has brought about optimism, spending and growth. Economic activity in the region's largest country picked up significantly in the second quarter particularly in the manufacturing sector as factory orders, industrial production, service and manufacturing sector PMI surveys all beat expectations. Although retail sales were weak in the month of May, the retail PMI survey for the month of June forecasts strong spending as the index more properly reflects consumer behavior during the World Cup. In fact, the country was so optimistic that consumer confidence hit a five year high last month while business confidence also saw a nice rise. However accelerated economic activity was not limited to Germany alone. France and Italy have both seen improved performance. Yet the question is not how the Eurozone economy has already performed, but how it will perform in the months to come. The World Cup is now over and many enthusiasts have returned home to their own countries which means that Europeans will have to work harder at generating their own growth. The German ZEW survey for the month of July is the first warning sign of the difficulties to come. Concerns about rising oil prices, Middle East tensions, political turmoil in Berlin and higher interest rates are all hurdles ahead. Thankfully, the Euro has retreated, which should help to boost the export sector and offset some of those risks.

How Far Will the ECB Go?

How well the economy holds up will help to determine how far the ECB will raise interest rates. With interest rates presently at 2.75 percent, it is widely expected that the central bank will bring rates up to 3.00 percent in early August. With inflationary pressures growing, the ECB has been forced to be extremely hawkish. As a vocal central bank that aims to limit market volatility and surprises, comments from the ECB require the greatest attention. In early July, central bank President Trichet cited the need to exercise strong vigilance to ensure price stability and to progressively withdraw monetary accommodation. They believe that monetary policy is still accommodative and as such, more rate hikes are needed. However, if the economy gives way and the region is unable to repeat the growth that we saw in the second quarter, the ECB may have their hands tied, just like they did between June 2003 and December 2005. They were forced to keep interest rates unchanged at 2 percent and were unable to reduce interest rates to spur growth because inflation was above their 2 percent target.

Reserve Diversification - Still a Big Positive

Slowly, but surely, reserve diversification continues to benefit the Euro. Last year, we heard a lot of talk about reserve diversification by countries like Russia, South Korea and India. This year, the United Arab Emirates joined the group by shifting 10 percent of their own reserves from dollars to Euros while Syria is planning to drop their dollar peg by year end. Of course, compared to many other countries, the UAE and Syria only have a small portfolio of reserves, but with talk of China still looking beyond US Treasuries, the Euro should find itself as one of the primary beneficiaries of this change in Chinese FX reserve policy, even if it simply means that China will stop accumulating US dollar reserves. East Asian countries own two thirds of the world's US$4 trillion of forex reserves, so their activity is particularly important. China has already been looking beyond the dollar as an investment over the past few months as they increase exposure to more tangible assets such as oil fields or gold. There is already evidence that reserve diversification is underway. In the month of May, central banks dumped $14.3 billion worth of bonds, the largest amount in over seven years.

Conclusion

In the first quarter of 2006, the EUR/USD went from being a trending to a range bound currency pair. We expect much of the same until the Federal Reserve "clears the air" by bringing their tightening campaign to a close. The timing of when that will happen will be dependent upon how high oil prices rise and how fast the economy slows. Once that comes to fruition, the market will turn its focus to the fundamental factors impacting the US dollar. If the Fed ended their tightening cycle because growth was taking a turn for the worse, then the outlook for the US dollar is even more dismal. If not, the US dollar still has the issues of reserve diversification, protectionism, and the current account deficit to contend with. However, if the rest of the world slows as well and the ECB is also forced to end their rate hikes, the direction of the dollar will depend on who is performing worse.

Technical Outlook

Last quarter's forecast mentioned that "a break of 1.2350, which is slightly above the April 7th high, would open the door for a move back towards 1.35." As we know now, that door was opened. After the sharp rally to 1.2970, the pair retraced a little more than 38.2% of the move from 1.1825 to 1.2971 - making a low on 6/23 at 1.2481. Going forward, there are of course two sides to every story and this one is no different. The most recent rejection at 1.2976 makes the rally from the November 2005 low at 1.1640 a 3 wave (a-b-c) correction of the 5 wave decline from 1.3666 to 1.1640 and therefore a possible important top. 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 1.2460, which is the 100-week SMA 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. The current price is at a trendline that dates back from the 2/27 low at 1.1825 and prices could very well rally to test daily highs at 7/7 (1.2859) or 6/5 (1.2976). It is behavior at this point that will be critical in determining the next direction of the EUR/USD because a move above the 1.36 high would invalidate the entire Elliott Wave outlook.