Euro-Dollar Trading Faces a Crossroad

Despite media certainty, there remain a lot of questions on the future direction of the currencies.
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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


policy. Several high-profile investment banks that had been looking for Fed cuts this year have thrown in the towel, and a


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.

The December Euribor futures contract rose 4.5 ticks Wednesday and has come off 2.5 ticks today. A price that implies 4.54% yield on three months' money in six months' time is consistent with 100% confidence of a 25-basis-point hike, recognizing that 4.50% is more likely than rates peaking at 4.25%.

Still, the market cannot be 100% confident of that move to 4.5%, and it wasn't prior to yesterday's press conference. There seems to be little compelling evidence that the collective wisdom of the market was persuaded one way or the other by Trichet.

When looking at the euro, I have often found the five- and 20-day moving averages helpful in detecting short-term and long-term trends. The five-day average moved below the 20-day average back in early May, generating a bearish signal. However, the euro's downside momentum faded as May drew to a close and we anticipated the euro's recovery. Its three-day bounce following its resilience in the face of the stronger-than-expected U.S. jobs and ISM data last Friday has been sufficient now to push the five-day moving average back above the 20-day moving average, ostensibly generating a bullish euro signal.

While I am sympathetic to the view, it is important to keep in mind that moving-average crossover approaches can generate whipsawing signals in a sideways market. A break of the $1.3450 area needs to be respected; it would warn that the dollar's upside correction is not over and would suggest near-term potential toward $1.3370. On the upside, a move above the $1.3520-$1.3530 downtrend line would lend confirmation to the more bullish outlook.

Marc Chandler has been covering the global capital markets in one fashion or another for nearly 20 years, working at economic consulting firms and global investment banks. Currently, he is the chief foreign exchange strategist at Brown Brothers Harriman. Recently, Chandler was the chief currency strategist for HSBC Bank USA. He is a prolific writer and speaker and appears regularly on CNBC. In addition to being quoted in the financial press, Chandler is often a guest writer for the Financial Times. He also teaches at New York University, where he is an associate professor in the School of Continuing and Professional Studies. While Chandler cannot provide investment advice or recommendations, he appreciates your feedback;

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