The Eurozone's Now in the Drop Zone!

Joined : 23 Dec 2007 Posts : 217 Location : Nigeria

Today's commentary is by Sean Hyman, our Currency Director and editor of The Money Trader.

Good Day Currency Traders!

European fundamentals are eroding. Yesterday, the German purchasing managers' index (PMI) for services dropped below a key support level in the Eurozone's largest economy.

PMI numbers measure the economic health of the manufacturing sector. And according to the numbers - Germany's manufacturing sector is anything but healthy. The numbers came in at 49.2 vs. the expected 50.5. That's the slowest growth in four and a half years.

On top of that, the Retail Sales figures came out too. Retail sales were -0.1% instead of the expected 0.2%. Even worse, last month's numbers were revised, so they're now lower also. With these new revisions, it makes this the worst drop since 1995.

Europe Will Crumble Under the Weight of
Its Crushing Exchange Rate

We're starting to see Europe suffer, just as I predicted. It's simple: Europe can't maintain an exchange rate of €1.50 to the dollar. That's an exchange rate that's up there in the stratospheric levels. This ultra-high exchange rate is killing the Eurozone's export sector.

On top of all of this, the Eurozone exports tons of goods to its second biggest customer, the United States. So if the U.S. is slowing down, Europe will feel it. The financial journalists have been saying this won't happen for some time. These shortsighted commentators act like Europe is immune to the U.S. slowdown. However, there's no such thing in this "interconnected" world.

There's a double whammy for the Eurozone. They're struggling with an extremely high exchange rate. On top of that, one of Europe's largest trading partners is slowing. In short, the Europeans didn't stand a chance.
What Happens When the "Anti-Dollar"
Has a Bad Year
There is a silver lining to all this. The euro exchange rate will come down against the buck this year. That's another reason why I've been saying the dollar won't fall as it has in past years.

Just as the euro is the "anti-dollar," a falling euro is the "pro-dollar." So a falling euro will support the greenback and force the dollar to hover above 30-year-lows. It wouldn't surprise me to see the EUR/USD exchange rate fall to at least 1.3600 this year. I also see that happening when European Central Bank President Trichet finally cuts rates later this year to halt the slowing economy.

The Eurozone inflation is holding around 3.2% right now, but I believe inflation will start to drop back toward the 2% level - the central bank's limit this year.

Even Consumer Sentiment is falling off lately. Last month, the consumer sentiment gauge in the Eurozone fell to 101.7 - the lowest reading since January 2006.

So the EUR/USD exchange rate responded to all of this overnight data by falling below support and dropping almost 150 pips. Wow! Check out the chart below.

Heads Up! Euro Takes a 150 Pip Dive

Expect to see the euro fall even further in the upcoming weeks to months. The euro is flying way too high. It will eventually come back to earth. Plus, as central bankers around the world cut global interest rates, many currencies will go down. As they go down, it will push money into the U.S. dollar.

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Making 'Cents' of the Headlines
The Aussies Can Hike Rates if They Want -
Their Economy Will Still Slow

From Currency Director: Sean Hyman

What's Happening:

Yesterday, the Australian Central Bank once again jacked up their interest rates - this time to 7%.

Of course, the Aussies still hold the distinction of having one of the highest interest rates of the seven major currencies. That's also officially the highest that rates have been in 11 years.

Why did the Australian Central Bank raise rates once again? Simple answer: They're still struggling with inflation "down under." Central banker Stevens said that a "significant slowing in demand" is needed to cool inflation.

What I Say:

I've been saying for a while now that Australia has the highest inflation in the industrialized world. Australia also has the strongest fundamentals of any of the major industrialized countries. The rate hike will initially be good for the Aussie dollar. However, in time, all of these rate hikes will eventually slow the economy. So what has kept Australia strong while other nations around the world - from the U.K. to Canada - are slumping and cutting rates? The answer...China.

The Chinese are creating a huge demand for mineral resources, and Australia is only too happy to meet those demands. That's caused the mining companies to hire additional workers which helped keep the labor market tighten. Since there's a labor shortage, the prices of wages are getting driven upward. Since the economy has been running "on all cylinders," the prices of fuel, food and housing have been driven up as well. So you can see that inflation has been rising on every front.

This rise in demand has kept inflation above the central banks 2% to 3% target rate for two quarters now. So that's what forced their hand and made the Australian Central Bank raise rates yesterday. So far, no one else is raising rates but Australia. ECB President Trichet acts like he's going to raise rates, but I'll have to see it to believe it. I think Trichet is "all bark and no bite" at this point. We'll hear the ECB's rate decision on Thursday morning.

Now back to Australia...this marks the 11th rate increase from 2002 when they started raising rates. Now the Aussie dollar has a 4% advantage over the U.S. dollar. Lately, that's what has kept the Aussie dollar supported and heading higher against the buck.

Money loves to run to high and expanding rates because these currencies get more yield. The thought of a higher return is what's caused the Aussie to rally a whopping 17% against the U.S. dollar last year.

Check out the hourly chart below to see how the Aussie has fared recently against the U.S. dollar. As you can see, the Aussie dollar has loved the news of the rate hike.

The Aussie Dollar Takes Flight as the Aussies Struggle with Inflation

But the central bank is really trying to slow things down big time now. They are trying to slow domestic spending substantially so that inflation will ease.

The government is starting to do their part by easing government spending ever since the new Prime Minister took office. So they're working together with the central bank to solve the inflation in the country.

While the "land down under" has expanded for 16 years, that expansion may be coming to an end later on this year or early next year. The rate hikes from months ago are starting to take hold. I'm seeing the first signs of weakening fundamentals in the Aussie economy just now.

For instance, the All Ordinaries Index of stocks suffered the worst monthly decline in 20 years in the month of January. Consumer confidence has fallen the most in 14 months. Home building approvals just fell 16% yesterday and retail sales slowed to 0.5% from 0.8% previously.

I've hardly seen any signs of weakening until now. So I believe the Aussie economy will start to finally cool off after its awesome 16-year-run. This will take some time but this kangaroo may not hop into 2009 quite so strong.