Euro Hits Record High, How Much Further Can it Rise?

It has been an extremely active day in the currency markets with the US dollar falling to record lows against the Euro and 30 year lows against the Canadian dollar. For months, the currency market has been obsessed with 1.40 in the Euro and 1.0 in USD/CAD. Now that these targets have been achieved, the question ahead of us is how much further can the Euro rise. In the currency markets, trends can last far longer than most traders expect and even though the risk of a top increases with each pip rise, there is no reason to believe that the EUR/USD will top out until the currency pair itself manifests weakness.

Fundamentally, the US dollar has been driven to a record low because of growing concerns about the US economy and the possibility of further interest rate cuts by the Federal Reserve. Although speculation of Saudi Arabia abandoning its dollar peg triggered the break of 1.40, the country’s later denial of this possibility did not lead to similar relief rally in the US dollar.

Therefore this tells us that there is a lot more than speculation driving the dollar’s weakness. We have often said that the expectation of where interest rates are headed is the number one driver of currency movements. The latest bout of dollar weakness is a reflection of not only the larger rate cut delivered by the Federal Reserve earlier this week, but also the expectation of anywhere between 25bp to 50bp of further easing before the end of the year. Yet, the further the dollar falls, the greater the risk of a reversal. A weakening currency will not only help to boost exports and revive the economy, but it will also induce inflationary pressures. So the question in front of us is what will get out of hand first, growth or inflation.

All it takes for the Euro to stop rising is a few pieces of stronger US economic data or any concern about Euro strength by ECB President Trichet. Unfortunately we have yet to see a meaningful improvement in US data. Even though the Philly Fed index jumped from 0 to 10.9, it was offset by a larger than expected drop in leading indicators. Fed Chairman Ben Bernanke made no direct comments about the state of the economy or monetary policy. He simply said that the rate cut was taken to stay ahead of the credit markets. Meanwhile gold prices hit 28 year highs while oil prices hit a new record high of $83 a barrel. Read our special report for more on whether it is a Coincidence that the US dollar, Canadian Dollar, Oil and Gold are Breaking Significant Levels at the Same Time.

Can Europe Handle 1.40 Euro?

Back in 2005 when the Euro was trading at 1.17, we use to say that the path to a stronger Euro was through a weaker one. Now, we hold the reverse view, which is that the Euro’s strength will be what triggers a weaker currency. Since the Eurozone is heavily dependent upon exports a weak currency goes a long way in boosting growth while a strong one will crimp it. Therefore we expect Eurozone economic data to begin to deteriorate in the months forward as 1.40 Euro begins to have a meaningful impact on the overall economy.

At this point, there is no need for a further interest rate hike from the ECB because even though rising oil prices are stoking inflationary pressures, a rising currency will offset some of that pressure. Going forward we also expect the corporate sector to loudly complain about the strength of the Euro. The French have been screaming for months and the Germans should soon follow suit. This may eventually force Trichet to drop his optimistic outlook, which would trigger a top in the Euro.

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