Euro-Dollar Trading Faces a Crossroad

When grappling with the euro-dollar exchange rate, I have tended to emphasize short-term interest rate differentials, and I now use the December Euribor and December Eurodollar spread.

That spread sits at 79 basis points today, which is within about a basis point of its six-month average, and the spread yesterday and today is the widest since early April. The slight widening has taken place at higher absolute interest rates. Since late March, both the December Euribor and December Eurodollar futures contracts imply around 70-basis-point higher interest rates.

This reflects in part a shift in expectations of Fed policy. Several high-profile investment banks that had been looking for Fed cuts this year have thrown in the towel, and a Reuters poll found that five of the 18 U.S. primary dealers now believe that the next Fed move is a hike. That leaves 10 dealers still looking for a cut and three without an answer.

Some observers might want to blame ECB President Jean-Claude Trichet's comments for the weaker euro and stronger dollar. I disagree with those observers who read Trichet as somewhat less than hawkish. Monetary policy is still accommodative; the risks are on the upside.

Some pundits suggest that the downward revision of growth or some subtle reading of the verbal entrails means that the ECB is getting near the end of its tightening cycle, but that just belabors the obvious. Nearly everyone is on board with that idea, and they were before yesterday's press conference. The market had an exaggerated knee-jerk reaction not just to Trichet but to the largest drop in European shares in two months.