UK: Euro - the New Dollar?

Last Updated: 7 February 2005
Article by Rupert Lee-Browne

Rupert Lee-Browne, Managing Director at Caxton FX looks at the latest economic factors to affect the single currency and why it is getting stronger.

"It is a brutal development. It will be discussed, but issues on exchange rates are to be discussed behind closed doors." Hans Eichel, the German Finance minister expresses his concern over the ever increasing value of the euro. However, the actions of European officials seem to be the mirror opposite of their American counterparts. US authorities claim they want a strong dollar, yet do nothing to prevent it’s slide. The Europeans on the other hand fret about the ever escalating euro, yet they too do nothing substantive to stem the rise.

Over the past few months the weakness in the U.S dollar has had a very large effect on the overall value of the Euro and its relationship with other currencies. As the dollar's rate of exchange continues to fall against the world's major currencies, there has been much speculation that the euro is seen as the new safe haven currency. One area receiving a lot of attention is the crude oil market in general, and OPEC in particular. It has been suggested that OPEC may begin pricing crude oil in terms of the euro, and further, that OPEC may actually begin invoicing its crude oil exports in euros. This latter step would require purchasers of crude shifting out of US Dollars, with OPEC receiving euros in payment. This suggestion (and it is only a suggestion) has done nothing but help the Dollar weaken further against the single currency.

Against the Pound the rise of the euro has been particularly marked. This can be credited to a number of factors. Primarily the U.K housing market is undoubtedly slowing and is looking increasingly less enticing. The latest house price survey from the Royal Institution of Chartered Surveyors showed that in the three months to October, 41% more surveyors reported a fall in house prices than a rise, 12 pct more than in September and the highest number reporting a drop since December 1992. RICS attributed the falls to a lack of new buyers, with the number of sales falling by 25 pct from the same period a year ago to hit its lowest level in 9 years. This has resulted in many market analysts adjusting their interest rate expectations and, as we discussed last month, many suggesting that we have now reached the top of the interest cycle this time around. Given that we are now moving into an election year we are unlikely to see another interest rate movement for sometime and quite probably the next movement will be down. This being the case, we can only expect Sterling to fall further against the euro.

In the Euro zone, on the other hand, the next interest rate movement may be upwards. While domestic demand remains the only missing component of a European recovery, many believe that this due to the fact that the oil price has remained consistently high over the past few months. Just look back a few months and most comments from the ECB pointed to an interest rate increase before the end of the year. In fact policy makers in Europe have said as much and it is likely that when the oil price abates we will see the first of a series of European interest rate rises, likely to start in the middle of 2005.

However it is not cut and dried as there are certain areas of the Euro economy that are of concern, although, mostly on a country specific level. To begin with, there are acknowledged property market bubbles in Spain and Ireland. Also other Euro zone countries, particularly France and Italy, have recently begun to exhibit certain excessive trends, It would be easy for the ECB to tighten monetary policy a bit in order to curb these excesses. However, until the oil price declines and a less uncertain economic times prevail it will be hard for them to justify a rate hike. The risks are that the oil price will not decline and Germany goes deeper into recession. This will allow the current imbalance caused by an overly accommodative monetary policy to gain steam possibly causing an economic bubble that, as in times gone by, would surely burst.

Much will be revealed over the coming months and in February I would expecting to be telling you about a lower oil price and the timing of a euro zone interest rate rise. Most forecasters are predicting continued strength in the euro and further weakness in the Pound and from a forecaster’s point of view this all adds up to a target Interbank rate of around 1.38. This fits well with the train of thought that Eurozone interest rates will rise in 2005. This should have the effect, as it has done in the U.K, of cooling European housing markets. Much will depend on the dollar and any possible intervention by the European Central Bank to protect the Eurozone’s export market. What ever happens we wish you all a prosperous 2005.

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