Easy vs Tight Policy

What has been interesting about this dollar rally has been what the waves have done in destroying the rallies in the other majors. For example, from the double top in the Euro around 1.60 and the double bottom in the USD around 71.70, several currencies have been pummelled lower. The Aussie dollar, suffering from overtight policy, has been crippled by almost 20% from the highs. This is a currency we are talking about by the way and not a tech stock. The British Pound, another currency suffering from overtight policy, also has taken a beating lower, falling almost 14% lower. Lastly, the Euro has backed off by about 10% - it too also suffering from overtight policy.

On the other side of the ledger, the Canadian Dollar, which has been tracking crude somewhat closely, is trading decently for the most part as the Bank of Canada (BOC) has been maintaining policy somewhat easy relative to its fundamentals. The Bank of Japan, the current proud member of a government in disarray but also featuring an easy policy mandate, has seen the Yen hold up well globally. Lastly, the good old greenback, the one that every bear has come to hate and blame for the current blow ups globally, also features ultraeasy policy.

So essentially what the currency market is doing is giving those currencies with easy policy mandates the benefit of the doubt going forward that essentially these currencies will be hiking rates in the coming future thanks to stable inflation pictures and rising growth. Those currencies that have tight policies will only feature rising growth if the policy is loosened. Till that point, the selling will follow which makes the Euro extremely interesting over the next six months.

The European Central Banks' current overnight rate, 4.25%, is restrictive in my opinion using a combination of models that have the core rate of inflation, growth, market inflation and market growth. I could explain these in more depth but that might take many pages so lets just summarize. Generally speaking, when growth is rising and policy is easy, the understanding in the marketplace is that the local central bank will have to hike rates. This will drive up overnight interest rates and support the given currency - sort of what we saw with the euro for the pats few years or even the Aussie the past few years.

At the moment, the Eurozone features shrinking growth, moderating core inflation, moderating market inflation (just watch the CRB for a good correlation there) and moderating growth (bull or bear model I often site is involved here). Going forward from here, the forecasts for European economy are for lower growth, moderating core inflation (last flash estimate dropped) and I believe that the market inflation picture will continue to moderate and on the growth side, I maintain we remain in a bear market so I don't expect that to rise anytime soon. All of this while the ECB is about 50bps too tight at the moment - meaning rates should be 3.75% vs the 4.25% used. The longer this persists, the more likely that the Eurozone variables, growth and inflation, will continue to fall and this will make conditions even tighter.

As we saw with the US economy following the breakdown in the dollar earlier in the decade, it took ultraeasy policy just to reverse the downward pressure that the strong dollar and tight policy, combined with a bursting equity bubble, to change the trend (and even that did not work as well). Back in 2000, the Federal Reserve was tight by almost 100bps when the stock market began its decent following the rallies in August 2000. The day the ECB hiked a few months ago began or increased the volatility throughout the marketplace. It also punched the EU economy in the gut and here we are today.

So what does this have to do with the Euro? Well, as it probably has been well chronicled, the Euro has fallen hard over the past month. Like my crude has support at 111.50 level call a few weeks ago (once that level broke today, crude collapsed), the Euro now has a similar setup showing on the chart. As the long term chart here shows, is sitting on a trendline that has held support since 2002. A break of this trendline very well confirms the breakout in the dollar to the upside. The dollar index has already climbed past its long term downward drawn trendline - now if the Euro breaks through, currency trading over the next 4-6 years might be much different. This could also create interesting changes to the US economy (that will be covered in another piece sometime).

Bottom line is simple here. If the month of September continues to be a month where the dollar is supported, the Euro could be on its way towards the 1.35 level and then the 1.20 level. If the ECB responds by cutting rates in the next few months or at least signals that such might occur, I think the 1.35 level will hold. Otherwise, I would argue that the 1.20 level is coming over the next few years. the longer the ECB holds out, the longer it will take to fix the damage.