The Eurodollar and the ECB

With the eurodollar making 22-month highs last week, largely in contrast to the bearish news of the Portuguese bail out, the question for treasurers and hedgers is whether the breakout is the beginning of a new bullish phase. It is extremely important to realise that the same story being repeated does not mean that the reaction will be the same, and this manifests itself in two basic forms.

Last year the ongoing woes in the European credit market saw bonds (particularly in Germany) rally throughout the Greece request for financial assistance and the euro collapse down to 1.19 againt the US dollar. All the market talk was overwhelmingly bearish and that par (one to the dollar) was coming soon. Then, when Ireland suffered a similar fate, bonds fell sharply and the euro rose. Why was this? It was due to the fact that the problems in the eurozone had been known for months and therefore, in this instance, the story was already reflected in the price.

The other cause of a different reaction to the same story is simply news fatigue. The news is not ‘new news’ and is therefore often dismissed. Almost a sense of boredom creeps in. This has been reflected in the muted reaction to the Portuguese bail out.

When analysing foreign exchange (FX), a key issue is the ability to decipher whether the price movement in a trend is due to the strength in one of the currencies, and the others’ weakness, or that actually both currencies are weak or strong, but just at a differing rate of change. Analysis of the daily eurodollar chart (Figure 1) shows a classic bullish breakout as price attempts to make the highest highs since February last year. This poses the question, is the breakout likely to be maintained?

Figure 1: Daily Eurodollar Chart November 2010 to April 2011


Source: CQG

First, by looking at the performance of the currency against a range of countries, it is clear that apart from the euroyen (which has surged and has its own dynamics due to yen weakness), the euro is in a downtrend against commodity beneficiaries and high yielding currencies such as the Australian and New Zealand dollars. This highlights that the eurodollar strength is really attributable to US dollar weakness. After the recent European Central Bank (ECB) rate hike, ECB president Jean-Claude Trichet stated that this was not necessarily the beginning of sequence of rates. However, rates are widely expected to be increased, which is being reflected in the interest rate curve. Normally when a change in the direction of interest rates occurs, this is the beginning of a sustained cycle of moves in the new direction. This, to a degree, has already priced in. Currently the markets expect interest rates to rise another 1% by December.

The market also knows that raising rates simply exacerbates the problems of the weak members of the euro and that the inflationary situation is beyond the control of central governments or central banks. Higher rates, therefore, will have little effect on pricing. The net result of any sustained period of rate rises is more likely to highlight the folly of a ‘one size fits all’ eurozone and lead to renewed weakness later in the year. The conclusion from an economic perspective is that, in this instance, the break out is likely to prove false. In the short term, a further caveat is the extreme reading that major banks take on sentiment for various currencies. Last week saw the highest bearish reading for the US dollar for many years, at less than 10% of those polled. Such extremes are a warning that everybody is already positioned in that direction.

From a technical analysis perspective, the eurodollar is trying to build a new higher trend, but there are some major obstacles above the current price. These resistance levels date back to the all-time highs in 2008 and the highs from late 2009. The first area of interest is especially strong at the zone between 1.4457 and 1.4546, and since the breakout of 8 April the price has stalled within this area.

Therefore it would take a weekly close above here to confirm a move to the next target at 1.5136. Until that happens this break higher is a false move and we can expect a move back into a broad sideways trend.

The daily chart (Figure 2) highlights the euro’s differing performance, as the recent rally in the eurodollar is in sharp contrast to the falls against the New Zealand and Australian dollars.

Figure 2: Daily Chart Comparison

Source: CQG

Looking ahead to this week’s calendar, today (Monday 18 April) sees the release of the ECB’s annual report, and on Tuesday the eurozone Purchasing Managers Index (PMI) for April. This is important as it is one of the more up-to-date statistics of the European economy, with the subsections forecast within an expansionary area between 57 and 58. Many of the broader statistics for the eurozone can be as far behind as three months, meaning that the market treats these as old news and has less impact. Wednesday’s German Produce Price Inflation (PPI) is also a key number in view of the ECB’s persistent focus on inflation. Thursday sees the same statistic for the US.

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