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June 07, 2005

Following the Trend of the Euro
by David Champeau

On January 4, 1999 the world witnessed the birth of the Euro currency. Eleven European countries fixed their currencies to the Euro. The world's financial systems were all upgraded to begin electronic trading of the single currency. Wim Duisenberg, a Dutchman, was the head of the European Central Bank. European politicians, like Gerhard Schröder, once very critical of the Euro idea, changed their stripes and sung praises for the smooth introduction. Hope had sprung eternal for Europe as they now had a currency to rival the US Dollar hegemony.

But as is usually the case, an unforeseen event changed the initial euphoria. It was called the NASDAQ bubble. One of the greatest spectacles of market mania ever witnessed, on the day the Euro began its electronic trading the NASDAQ opened up at 2178.21. In the next 14 months the NASDAQ would steal not only all the headlines, but also most of the speculative capital of the world as it rose to a high of 5048 in March 2000. The NASDAQ mania dragged the US dollar along for the ride and in the process drove the Euro/Dollar exchange rate from the opening 1.18 down to a low of 82 cents.

At the height of the NASDAQ mania we heard Larry Kudlow on CNBC use the phrase "King Dollar." The US dollar was indeed "king" but it was an emperor with no clothes. In Europe Wim Dusenburg was forced to withstand the insults coming from the press, which included the phrase "Dim Wim", supposedly given to him for his changing opinions on monetary policy. It is amazing what bull and bear markets can do. The Americans were dynamic geniuses and the Europeans were idiots.

While pundits were scratching their heads about the weakness in the Euro in 2000-2001, something else was happening. Central bankers of the industrialized world had been raising interest rates into 2000. The US Fed Funds rate hit 6% while ECB short rates went up to 4.75%. Then the NASDAQ ran out of gas and the central bankers turned around and started cutting rates. In 2001 Alan Greenspan could not cut rates fast enough and by the end of 2001 Fed Funds rates were at 1.75% while ECB rates went down to 3.25%.

It is this time period, particularly during April and May 2001, where Fed Funds rate moved below ECB short rate. The US Dollar Index was making a massive top with a double top at 121 while the Euro/Dollar cross rate was making a large bottom between 82 and 95 cents.

On January 1, 2002 the ECB introduced the official notes and coins which replaced the national currencies in people's pockets. Thus the Euro became a real currency. The exchange rate with the US dollar was still about 90 cents but the bottom was being completed. As 2002 unfolded, the Euro began to move higher and the US Dollar Index began to move lower.

By the beginning of 2003 the Euro/Dollar exchange rate was above parity and moving higher quickly. The "catch phrase" in the media had changed from "Dim Wim" to "dollar benign neglect." The US government was still spouting the "strong dollar" policy without ever defining what that meant. Pundits accused the administration of wanting a lower dollar. The central banks were still lowering interest rates occasionally and by the end of 2003 the Fed Funds rate stood at 1% and the ECB short rate stood at 2%. Jean-Claude Trichet was now the head of the ECB and the Euro/Dollar exchange rate had returned to where it started in the 118 range, even exceeding 118 in May 2003.

At the end of 2003 the catch phrase in the media had changed from "dollar benign neglect" to "twin deficits." The Bush administration and the US Congress were spending like drunken sailors and the US trade deficit was skyrocketing into the stratosphere with billions of dollars being shipped to China every month. The whole world was wondering "how much can the US spend?" "Was all this spending and debt accumulation good for the global economy or would it end in ruin?" At the end of 2003 the Euro/Dollar exchange rate stood at 1.25 and was poised to move higher.

At this point in time the global economy was recovering, and the leader was the commodity area. China was buying everything in site and a huge bull market in commodities was on. The price of crude oil in US dollars was shooting higher trying to break through $40 a barrel. In Euro terms the price was moving sideways as the rise in the currency offset the price rise in US dollars. It was a weak dollar story.

As 2004 moved along the Federal Reserve began to raise interest rates. At the end of 2004 the Fed Funds rate stood at 2.25% while the ECB rate was still at 2%. The Euro/Dollar exchange rate hit a high of 136 in December 2004. The media was talking about the Euro as a "great success" and was signing the death certificate of the US Dollar. The big question in the Euro zone was "How strong is too strong?" The big question in the US was "Will the dollar survive?"

In 2005 the Federal Reserve has continued to raise interest rates and at the end of June the Fed Funds rate will be at 3.25% while the ECB is still "on hold" at 2%. The US Dollar looks like it has made a bottom and is currently showing strength against the European currencies. The commodity currencies remain strong, as does the price of oil, copper and the CRB in general.

Success does funny things. As the global economy has been recovering, the Euro zone economy has been lagging the US economy. Growth is a low 1% or so in the Euro zone and the politicians are screaming at the ECB to cut rates even further while ignoring the fact that Germany has had 2 straight years of record exports in the face of the strong Euro. The ECB is standing its ground telling the national parliaments to enact market reforms so that the European market will be "dynamic" like the US market. Meanwhile the money supply in the Euro zone is growing at a healthy 8-9% a year. A classic example of a central bank that can control one thing, interest rates, but not two things, interest rates and money supply growth.

In March of 2005 the European commission relaxed the "standards" of the much-heralded Growth and Stability Pact, effectively ending any semblance of fiscal discipline in the Euro zone. The Euro promptly sold off on the Forex markets. Jean-Claude Trichet, the benefactor of the Euro strength for 2 years, is now under extreme pressure to "do something" to promote growth in the Euro zone.

Now in June 2005 we have the French and Dutch voting "No" to the EU Constitution. The European politicians are in disarray. They want the ECB to bail them out. Germany is at a standstill as the majority of the population fears they could lose their jobs. There are calls from Italy to bring back the Lira in a duel currency system. Tony Blair's government in England is rumored to be calling off the referendum on the EU Constitution. The EU Constitution looks dead. The EU Project has hit a wall for now and the Euro seems to be showing signs of a currency in trouble.

The rise of the Euro has followed a path defined by the catch phrases "Dim Wim, "Dollar benign nelgect", "Great Success", "How Strong is Too Strong". Now with the effective end of the Growth and Stability Pact and the EU Constitution, we will see just what the Euro is really made of. It has gone through one complete cycle, from introduction to bear market to bull market and global acceptance. This is a big boy's game and the currency markets can be a cruel place.

With the current 8-9% growth of the money supply, 1% economic growth and 2% interest rates, compared to the US Dollar's 4% money supply growth, 3-4% economic growth and 3%+ interest rates, the Euro is looking weak. The ECB talks hawkish and it seems that they would like to raise rates and slow down the money supply growth. But with the economies of the Euro zone growing ever more slowly their hands are tied.

Maybe the No votes this month will be a wake up call to Europe. My German friends believe that Herr Schröder will be voted out of office this fall. So does the Economist magazine. Signor Berlusconi in Italy is also on the ropes after his party Forza Italia lost big in regional elections earlier this year. Tony Blair won for a third time in the UK but with a smaller majority and will do nothing to rock the boat. In France Jacques Chirac is running around Europe trying to save what is left of the European project. Politicians all around Europe are circling the wagons and pointing their guns at the ECB to "do something." The pressure is mounting as the ECB's Trichet fends off talk about the demise of the Euro.

Booker T. Washington once said "I have learned that success is to be measured not so much by the position that one has reached in life as by the obstacles which he has overcome while trying to succeed." The Europeans have many obstacles that they must hurdle in order for the Euro to continue to be a success story for Europe.

Time will tell.

David Champeau

David Champeau has a blog where he spouts off every morning and a web site where he keeps his charts of interesting markets.

Copyright © 2005 David Champeau

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