We're not far off the capitulation point for the euro

Outlook: The third week of every month is the busy data week and always a tough row to hoe for those trying to put it in summary form and analyze it. This week it’s especially burdensome because we have earnings reports, too, something most Foreign Exchange Traders don’t have to spend much time on.

According to Wall Street guru Sandi Lynne (www.wallstreetinadvance.com), we get earnings from Wells Fargo on Wednesday and then a flood on Thursday--KKR Financial, JPMorgan, MGIC Investment, Bank of New York Mellon, CIT Financial, Comerica, PNC Financial, Capital One, Merrill Lynch, and Zion’s Bank, all before Citigroup reports Friday morning. Lynne notes that all week, in Boston, something will be held named the Annual Corporate Fraud Conference. In addition to the financials, also reporting are a slew of companies, including IBM, Microsoft, Google, eBay, Advanced Micro Devices, Coca Cola, Harley Davidson, and Mattel, to name just a few. Friday is options expiration day.

The economic releases are June PPI and retail sales on Tuesday, with CPI, industrial production and the May Treasury capital flow report on Wednesday. Also Wednesday is the National Association of Home Builder’s July Housing Market Index. Thursday brings June housing starts and building permits and the Philadelphia Fed July survey.

Institutional information usually trumps data and tomorrow we get Bernanke testifying before the House and then the next day to the Senate. The goal of the testimony is to offer the Fed’s economic forecasts and at least some of the underpinnings of how the Fed thinks about monetary policy going forward, but we imagine a great deal of time will be spent on trying to measure how much wasted time is going to be spent on the financial crisis.

We have almost no doubt that the Fed and the Treasury will succeed in tamping down hysteria over the potential failure of Fannie and Freddie. They are literally too big to fail—having underwritten one way or another over $5 trillion in home loans. It may turn out that they hold or sold more bad paper than we now suspect, but never mind—too big to fail means precisely that. Eventually panic will subside, perhaps as early as this week, but then we move on to the next thing—more regional bank failures like IndyMac. It seems likely that the Fed and Treasury will be preoccupied with these matters for a long time to come and talk of rate changes will get back-burnered to after year-end, as several forecasters have predicted.

The good news about the Fannie and Freddie debacle is that now it’s out in the open, having festered under a cover of hot air and misdirection for at least 20 years. Can Europe say the same? Nobody knows the quality of the paper used as collateral at the ECB. As we saw from various German bank failures over the years, Europeans may have higher credit standards and less fraud than the US, but their bankers are no more competent and sometimes a lot less competent than their US counterparts. On a one-to-one comparison, it’s not clear that the US financial system is more fragile or risky than Europe’s.

And when the mess does get cleaned up, US growth is almost certain to be earlier-appearing and more sprightly than in inflexible old Europe. Labor is the pivot point. In the US you can hire and fire someone without a problem, whereas in Europe to fire someone requires acres of paperwork. It’s that simple. Most analysts perceive that European recovery will lag US recovery when it does come, and that should be dollar-friendly. As UBS wrote last week, we may get another hike from the ECB but then it is expected to be cutting in 2009 to boost activity—at the same time that the US could already be on the recovery path. Bloomberg writes that “The ECB will cut the key rate a quarter-percentage point to 4 percent by the end of June 2009, according to the median of 30 economists in a Bloomberg survey.”

Out of such perception may come a dollar rally scenario. This seems to be the view of currency analysts at Bank of America, Morgan Stanley, BNP Paribas, and surprise! Bill Gross at Pimco, not a perennial dollar bear, after all. London forecaster Calyon says “We're not far off the capitulation point for the euro.”

This is almost certainly premature, and the relief rally of the dollar may not have much lasting power if data continues to come in bad this week. A lot depends on Bernanke’s tone tomorrow. If he sounds sacred, everyone else will get scared, too. And there is, of course, a very large fly in the ointment—commodity prices in general and oil in particular. No matter how much reassurance is issued and believed about the ultimate fate of the financial sector, oil looms over everything. Higher oil prices—and $150 is within smelling distance—is not US Dollar friendly. In short, we are not ready and willing to buy into a US Dollar rally scenario just yet.