We say that foreign exchange traders are wrong

Foreign Currency Exchange Outlook : Three things seem to be on the table this week - the price of oil, US nonfarm payrolls on Friday, and the latest OECD forecasts. Yes, the OECD. We pay attention to the OECD only when it suits us. The OECD is a political hornet’s nest whose output has to be sanitized so deeply that most of the time, it has thrown the baby out with the bathwater. This time it has cut forecasts for growth in the UK and eurozone by a lot, projecting the UK will get growth of only 1.2% this year, implying the second half will be flat or a contraction. For the eurozone, growth will be 1.3% (from 1.7%), just avoiding the technical definition of recession.

Meanwhile, the US got an upward revision, from 1.2% to 1.8%, due to the surprisngly good Q2 data. As we point out from time to time, growth counts. Over the long run, currencies tend to be positively correlated with the relative rate of growth of the economy. The country with the higher growth gets the stronger currency. This observation is fraught with exceptions and qualifications. Higher growth generally brings higher inflation and thus the real interest rate has to reflect growth + inflation for the “rule” to work.

In the US today, we hardly have interest rates reflecting a relatively better growth outlook than the UK and eurozone. But the implication is that the US “should” have those higher rates (while the UK and eurozone “should” have lower rates to goose growth). Foreign Exchange Traders sometimes trade on what should be rather than what is in front of their face. The ECB meets this week and is expected to leave rates on hold, but since foreign exchange traders think the ECB “should” be thinking about rates cuts—the Bundesbank’s Mr. Weber notwithstanding—Mr. Trichet is sailing against the wind to speak hawkishly and mention vigilance against inflation.
In other words, foreign exchange traders will again assume facts not in evidence. They are simply unwilling to believe that the ECB has a single mandate, inflation. They want the ECB to respond to growth worries and reject repeated ECB assertions that it will not heed slow-growth data.

It’s seemingly not “natural” for a central bank to be so single-minded.

We say that foreign exchange traders are wrong.

The ECB is that single-minded.

As Market News reported on Friday, the ECB is likely to remain on hold for the remainder of the year. Funny, so is the BoE, which also meets Sept 4 but is not expected to cut rates this time (from 5%). Instead it is proposing some goofy minor patch-jobs on the margins of the housing market, a semi-pinko effort at a solution that will end up being adminstered unevenly and result in fresh distortions of allocations.

Why is the Bank of Englaind not cutting rates?

At a guess, it wants to be seen as equally anti-inflation as the ECB.

The OECD says the ECB should remain on guard against rising core inflation, the Fed should continue to support the economy against financial constraints, and the BoJ should remain on hold against deflationary risks—in other words, no change. We feel it is unlikely that nothing will change in the next four months…

It’s official - we were right to say we can afford to think Big. We can see no real reason for the dollar not to correct to midway down the euro’s uptrend since Oct 2000, or 1.2176.

The intermediate low in that super-move is 1.1639 in November ’05. Why not?

Bye For Now

Barbara Rockefeller

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