.... In order to get an idea of how exchange rates may change, we need to get an idea regarding how the central banks might adjust policy.
Federal Reserve-Currently on hold after ending the easing cycle. Its next move, which will not occur for many months, is more likely to be to the upside but there's no indication at the present time when this might happen and even if it does, the possibility exists that it would be a "one and done" move similar to what the ECB did at its July 3rd meeting. The "slow motion" recession in the U.S. is likely to continue in spite of the fact that Q2 (and possibly Q3) GDP will look better than Q1 due to the temporary effects of the tax rebates. Major U.S. banks and financial firms are still in the process of de-leveraging and raising capital, so in this environment it's hard to imagine the Fed making a policy change that will increase the cost of money.
From an inflation perspective, using the PCE numbers, a rate increase is not yet indicated since headline inflation in the year to May was 3.1% while core PCE (the Fed's preferred measure) was just 2.1% after a monthly increase of only 0.1% (for the second month in a row), evidence that higher food and energy costs are not yet spilling over to core measures. And while the monthly headline number (0.4%) was the highest since November's 0.6% reading, year over year PCE has declined every month since January. Additionally, pending the June numbers, it looks like the year over year core PCE will decrease on a quarterly basis in Q2. Significantly, there is no evidence that the wage-price spiral of the 1970's is anywhere in evidence (nor is it likely to be) because today's mostly non-unionized workers have little bargaining power. Hourly earnings increased 3.4% in the year to June, down from the 4.2% cycle high from December 2006. This does not mean the Fed won't be making hawkish sounds, as consumer inflation expectations have risen to levels last seen during the early 1980's double-dip recession.
Aside from this are the continuing problems in the housing market (prices decreasing while inventories are increasing as foreclosures and home equity loan default rates rise), not to mention the fact that conventional fixed-rate mortgages are only about 25 basis points cheaper than last year (after 325 basis points of Fed easing) and that jumbo loans are more expensive (in addition to both types being far more difficult to obtain).
As previously mentioned even if the Fed were to increase rates by 25 basis points as we have seen with the ECB and the euro, an increase in and of itself won't cause the dollar to enter a strengthening trend if they make a "one and done" move by indicating that a series of rate increases are not planned and I do believe the chances of the Fed entering a tightening cycle within the next six months are virtually non-existent.
European Central Bank-Currently on hold after making its first increase in more than a year. The ECB presently has "no bias," which means it can move either way depending on the circumstances although at this time, there's no indication when this might occur. With Denmark already contracting, Ireland projected to do the same (the Economic and Social Research Institute forecast that GDP growth in Ireland will be negative in 2008 at -0.4%) and trouble for France, Italy, Spain and Portugal on the horizon, and with European banks also facing their own set of capital-raising problems, it's more likely to see the ECB's next move be to the downside but the probability for this to happen by the end of the year is remote. Even mighty Germany is showing signs of stress-In May, manufacturing orders declined for the sixth consecutive month, falling 0.9% from April on weaker domestic demand.
Bank of England-Of the three, the economy most at risk for a sharper recession is the U.K., due to big slowdowns in the services (the index declined to 47.1 from 49.8 in May, its lowest level in six and a half years), and housing sectors. The bank believes that slackening demand should help reduce inflation (currently 4.0%), which they expect to peak by the end of the year however, the bank is likely to continue their plan of making "month-to-month judgments."
Putting this all together means that exchange rates among the three are likely to range trade for the present time and that a clear trend is unlikely to emerge until future policy moves can be better appreciated. And although there will be times when traders may believe policy may be changed one way or the other, it's very unlikely to see the Fed or ECB move before the end of the year and virtually no chance exists to see the Fed enter a tightening cycle. The biggest chance to see another policy adjustment lies with the BoE (down), but that's far from being certain.
What I do feel very strongly about is that the euro appreciation is over, as it has been since mid-April, and that a real trend of dollar appreciation cannot start without it becoming apparent that the Fed entering a tightening cycle. To put some numbers on this it does seem likely that EUR/USD will test the channel lows in the lower 1.5300's, but that a sustained trend of dollar appreciation is highly unlikely this year...
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