Is Euro Destined for Parity?

EUR: DESTINED FOR PARITY?

The biggest story in the financial market continues to be the weakness of the euro. In the past 24 hours, the currency has blown through its 1.25 and 1.24 support levels and is now trading just a hair above its lowest level against the U.S. dollar since October 2008, the same month that Lehman Brothers’ collapsed. The extremeness of the recent price action suggests that investors are just as nervous about the current market environment as they were about the economic outlook back in late 2008.  However the big difference is that back then, the problems stemmed from the U.S. and today, the problems are in Europe. This has encouraged investors to buy dollars for both save haven and relative growth prospects. The latest breakdown in the EUR/USD was triggered by concerns that the Eurozone could breakup as a result of the sovereign debt crisis. In turn, the weakness in the EUR/USD has raised questions about whether the currency pair is destined for parity, where one euro is worth one U.S. dollar.  
Is Euro Destined for Parity?
The last time the EUR/USD traded at parity was in 2002 and at that time it was rising from lower levels. If the currency pair broke its October low of 1.2329, which is not very far from current levels, it would take the EUR/USD to its lowest since April 2006.  Given the rapid response of global policymakers to the volatility in the financial markets on Thursday, there is only a very small chance that the ECB would allow the euro to reach parity without attempting to stop its fall. Although a weak currency helps to boost growth, there comes a point when it becomes a greater risk to inflation and a threat to the growth in other countries. The only possible scenario under which the EUR/USD could reach that point would be if the euro was at the brink of dissolution. Part of the reason why the euro fell so significantly today was because of French President Sarkozy’s threat to leave the Eurozone if other members (ahem, Germany) does not approve the EU/IMF rescue plan. Germany is dragging their feet in getting Parliamentary approval which is one of the unanswered questions that we outlined when the rescue package was first unveiled. Until this and other issues are addressed, investors will be weary of holding euros. However given that Angela Merkel admitted today that things would be a lot worse if the EU and euro did not exist, there is a good chance that Germany could approval the package soon. There are too many benefits to having the euro and too many consequences or complications with returning to individual currencies that the euro is not going anywhere anytime soon. It is much more likely that other countries within the Eurozone will vote to force out their weakest links than to dissolve the monetary union entirely.  Although we believe that the euro is not destined for parity, it should see more losses with a possible test of 1.20.
Euro: Destined to be a Funding Currency
What the euro is destined to be for at least the next year is a funding currency. Concerns about the impact of the austerity measures on growth are serious and the European Central Bank is fully aware of this. Therefore we expect the ECB to lean towards easier monetary policy for next few months with a possible return to quantitative easing. Unlimited repo tenders and purchases of government bonds are all actions of a dovish central bank. The only hope for the euro would be a positive reception to the final approval and implementation of the mammoth rescue package announced at the beginning of the week. The G7 could also intervene in the foreign exchange market and buy euros which would at minimum trigger a relief rally in the EUR/USD, shaking out shorts. The perfect time for central banks to intervene to buy euros is when the market is extremely short as short covering would compound the rally. According to the latest IMM data, euro short positions have once again climbed to a new high. If Parliamentary approval continues to be delayed and the ECB decides not to stem the currency’s slide, then another downgrade of Greece (which is very possible) could take the EUR/USD down to 1.20 and beyond.
Next week’s economic reports from the Euroozne will continue to take a back seat to the Sovereign Debt Crisis.  The German ZEW survey, IFO report, PMI and inflation numbers are scheduled for release.

USD: BENEFICIARY OF SAFE HAVEN AND RELATIVE GROWTH FLOWS

The U.S. dollar appreciated against every major currency except for the Japanese Yen as better than expected economic data makes the dollar more attractive from a relative growth and safe haven perspective. Based upon the latest consumer spending, industrial production and confidence reports, the U.S. economy is chugging along. The improvement in labor market has helped to turn the entire economy around, albeit at a glacial pace. Although the exposure of U.S. financial institutions to German banks and in turn, the exposure of German banks to Greek banks makes America exposed to Europe’s sovereign debt crisis, for the time being, investors are focused on the source and not the ripples. Even if the U.S. economy is affected, the Federal Reserve could still normalize monetary policy before the ECB. According to the retail sales report, US consumer spending grew at a slower pace in April but with the upward revision in March and the seventh straight monthly gain in spending, the drag on the dollar was minimal.  Both overall retail sales and sales excluding autos and gas rose 0.4 percent, beating expectations. However the big surprise was in the March figures which were revised significantly higher.  Instead of rising 1.6 percent the prior month, spending actually rose 2.1 percent.  Retail sales ex autos were revised up from 0.6 to 1.2 percent.  Demand was particularly strong for building materials, health care and personal care products but spending at department stores decreased due to the early Easter Holiday. Consumer spending growth may have slowed but it is growing and distortions can be mostly attributed to the holiday.  April was a strong month for retailers, but March was exceptionally strong.  Unfortunately, the pickup in U.S. consumer spending failed to stabilize risk and offset the jitteriness caused by the uncertainty in Europe. Meanwhile industrial production rose by 0.8 percent and capacity utilization increased from 73.1 to 73.7 percent which should not be all that surprising considering that manufacturing grew at its fastest pace since 2004.  According to the University of Michigan survey, consumer sentiment improved in May but not by as much as the market had anticipated which added salt to the wound and exacerbated the weakness even though normally, the improvement would be enough to stabilize risk.   In the week ahead, inflation, housing and manufacturing reports are due for release.  The Federal Reserve will also publish the minutes from their most recent monetary policy meeting while the Treasury will release the latest figures on foreign demand for U.S. dollars.

GBP: NEW GOVERNMENT TRIES TO GAIN YOUR RESPECT

The third straight decline in the pound brought the currency dangerously close to a new yearly low against the greenback. Still, today’s weakness capped the third straight week of pound declines. Sterling was pressured today by a sharp drop in U.K. stocks, which saw the benchmark index lower by the most in about six months. Clearly, traders are finding that the U.K. has much higher exposure to the European debt crisis than many other industrialized nations, especially due to their geographic proximity. Nevertheless, traders should be comforted somewhat by the fact that the new coalition government has wasted no time in proposing sweeping deficit reduction plans. Yesterday night marked the inauguration meeting of the new government, which concluded with an overwhelming seal of so far so good. Officials announced that their first plan of action would be to cut compensation of U.K. ministers by 5% as well as impose a strict freeze on salaries for the next five years. Even though things have been moving smoothly lately, it will take time for the new government to earn the market’s confidence. Separately, David Blanchflower, a former Bank of England policy maker, said that he would have like to see the bank boost its assets purchases “by a lot” at their last meeting, responding to growing expectations that the bank will have to ease further as the government tightens fiscal restraints. Blanchflower has traditionally been more dovish than his peers. Next week’s main event risks are Tuesday’s Consumer Price Index, Wednesday’s release of the BoE’s Minutes, and Thursday’s Retail Sales.

NZD: RETAIL SALES THREATEN CHANCES OF A JUNE RATE HIKE

Commodity currencies sold off as uncertainties in Europe overwhelm any trace of risk tolerance left in markets. USD/CAD shot lower by the most in a week, driven primarily by a plunge in oil prices that saw crude fall more than 3.5%. New Zealand’s Retail Sales were released today and were a broad disappointment, coming in at only half of consensus expectations. Retail Sales rose at the slowest pace in a year while core sales fell for the first time in four months at a critical in juncture that is sure to have consequences on the probability of a June rate hike by the Reserve Bank of New Zealand. Today’s clear sign of weakness presents a strong argument that the bank may have to wait longer than expected so not to stifle growth in a still hobbled economy. The sales report showed that performance improved in only slightly more than half of its underlying components, driven by vehicle sales and dragged by food and drink sales. New Zealand has the Performance of Services Index in store for Sunday night and Producer Prices for Monday. In Canada, Motor Vehicle Sales dropped sharply by 4.2%, while Manufacturing Shipments rose for 0.1% to 1.2%. Canada has its Leading Indicators and Consumer Price index due late next week. Australia, on the other hand, is set to release the RBA’s Minutes on Tuesday, Westpac Consumer Confidence on Wednesday, and Inflation Expectations on Thursday.

JPY: ALREADY SEEING EFFECTS OF STRONGER YEN

The Japanese yen strengthened against the dollar for the second straight day as traders, frightened by grim signs coming from Europe, chose to stock away their money in the safety of the yen. The story was very much the same across all actively traded currencies, with the commodity dollars noticing a particularly sharp loss against the currency. As expected, along with the yen’s gains today came a more than 20% rise in the Volatility Index, which explains the extent to which market worries have risen. Japan’s Nikkei 225 index was not insulated from today’s events, and fell 1.5%. Aside from global concerns, it has been primarily weak earnings forecasts that have been weighing on the index, an event many see as a direct result of the strengthening of the yen, which poses a significant threat to exporter profits. No economic data was released in Japan for today, but we are expecting more for next week. To start things off, we have the Tertiary Industry Index on Monday, to be followed by Consumer Confidence on Tuesday, preliminary GDP on Wednesday, and the BoJ’s rate decision on Thursday. It will be interesting to see whether the BoJ has changed their tone, especially after the two consecutive liquidity injections that took place last week.

 Unanswered Questions
 1. What will be the exact mechanics behind the Special Purpose Vehicle that will provide the EU440bn that is guaranteed by member states? What are the rules and terms
2. Will the SPV need to be approved by individual nations / Parliaments and if so, when will this happen? 
3. Will Greece accept these terms? Will they amend it?
4. Can all countries afford to contribute to the plan and will the countries seeking aid be able to handle the tough conditions that may accompany the loans ?
5. The  IMF supposedly has $268 billion left, where are they getting the rest of the money?
6. What is the size and scope of the ECB's bond purchases?
Although European policymakers and the G7 are committed to defending the euro, with many political hurdles ahead, the details need to be ironed out and it may be a while before it is finally implemented. 
At the same time, the ECB's decision to buy government bonds has also undermined the central bank's credibility. Last Thursday, ECB President Trichet said buying government bonds was not even discussed and 2 trading days later, the announcement was made. It is hard to believe that the central bank was not pressured into market intervention, particularly since the decision was not unanimous.  Investors are rightfully concerned that the central bank has not figured the details out and are simply providing additional firepower to the EU/IMF's announcement.   Ultimately, the fact that the ECB is implementing a light version of quantitative easing will limit the positive impact of the rescue plan.   The markets may not find support until the plan is finally implemented. 

EUR/USD: Currency in Play for Next 24 Hours

EUR/USD will be the currency pair in play for Monday. The Euro-zone will release New Car Registrations at 2:00 am ET or 6:00 GMT. The U.S. will be releasing the Empire State Manufacturing Survey at 8:30 am ET or 12:30 GMT, followed by Net Long-Term TIC Flows a half-hour later.
For five straight weeks, the euro has fallen, keeping EUR/USD well within the Bollinger band sell zone on both a daily and weekly basis. A major support is not too far away and lies at the October 2008 low of 1.2328. If this level were to be broken, we are talking about a new four-year low in EUR/USD. On the other hand, resistance can be found at the 10-day moving average, which lies at 1.2733, a level close to the lower one-standard deviation Bollinger band.