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Currency Forecast: EUR/USD Outlook

Although the euro reached record highs at the beginning of this year, the rally in the currency was not driven by positive European economic news. Instead, the rise in the unit was primarily fueled by massive bearish sentiment towards the dollar. However, now the tables have turned and the bearish sentiment in the EURUSD is being primarily driven by pessimistic sentiment towards Europe . The continent's economic woes have spilled over into the political arena following the rejection of the new EU Constitution. With the euro being an easy scapegoat for the inability of European politicians to spur growth in their own countries, Italy has led the pack in calling for the dissolution of the euro altogether. This speculation has been the catalyst for the euro's extensive sell-off through the first half of the year. In fact, what has been happening is that the fundamental landscape for the EURUSD has changed completely. The currency pair used to shrug off any bad euro news, and reacted only based upon US developments, earning itself the title the "anti-dollar." Now, the currency pair reacts almost solely on euro news and shrugs off bad US data.

Fed's Rate Hikes Are Holding The Dollar Up
Part of the reason why EUR/USD has been able to ignore US data is because the US continues to aggressively raise interest rates, keeping the dollar bid. This is very important because the Federal Reserve is the only central bank to be aggressively raising rates this year. As a result, traders are buying back dollars to either reverse old carry trades (when they sold dollars as rates were being slashed to 1.00%) or to initiate new ones. In fact, this could even explain some of the confusion with long-term interest rates. The Fed is expected to bring rates back up to at least 3.50%, which means that there may be some more carry trade premium left in the dollar. However once the Fed is done tightening, we may finally get back to fundamentals, at which time, the sole pillar propping up the dollar could topple.

But Fundamentals In The US Are Deteriorating
Across the Atlantic, although the economies of the countries within the Eurozone still remain very weak, especially with Italy sliding back into recession, the 1600 pip slide in the EURUSD appears to be having some stimulative effect on the region's health. Eurozone industrial orders and the German ZEW survey are but only 2 economic indicators that have surprised on the upside. The US on the other hand has come out with a barrage of disappointing releases; In May of 2005, non-farm payrolls failed to reach 50% of expectations, consumer spending took a sharp dive, inflation pressures were very muted, the manufacturing sector showed signs of significant weakness with the Philadelphia Fed Survey plunging into negative territory, and the current account deficit ballooned to a new record high. Foreign purchases of dollar denominated assets also failed to meet the funding needs of the trade deficit for 2 consecutive months. Globally oil prices have shot to another record that will certainly hurt growth and consumer spending across the globe. The changing trend of economic data should be beneficial for the euro, yet with political factors and the Fed's aggressive rate hike campaign, the EURUSD could remain under pressure for a few more months.

Greenspan's Departure Could Be Positive For EURUSD
The end of the Fed's tightening cycle should coincide perfectly with increasing speculation of a replacement for Federal Reserve Chairman Alan Greenspan.  After having served under four different Presidents of both Republican and Democratic Administrations, the Fed Chairman is expected to leave office at the end of January, 2006.  As one of the most respected central bankers of our time, Greenspan has managed to navigate the nation through the 1987 Stock Market crash, the 1991 oil spike sparked by the Gulf War, the collapse of Long Term Capital Management in 1998, the burst of the NASDAQ bubble, and 9/11, with only minimal setbacks for the economy. During his tenure as Chairman, US GDP increased in 16 out of 17 years - one of the smoothest periods of economic growth in US history. Therefore it will be very difficult to a find a replacement for the world's most effective and esteemed central banker.  Right now, there has been minimal speculation for a replacement, but come late summer, early fall, talk of possible successors should be in full swing.  With no successor-possibility having as much respect as Greenspan has had with the financial markets, speculation about who his replacement will be will only cause more uncertainty for the US dollar.  This timing will coincide perfectly with the end of the Fed tightening cycle. 

Reserve Diversification Talk Subsides To A Whisper
Previous euro support from talk of reserve diversification has fallen to the sidelines as many countries wait to see how the EU developments pan out and if the euro is really here to stay. If you recall, last year, several central banks including the Bank of Russia as well as the central banks of various Middle Eastern governments began diversifying their reserve assets from dollars to euros, spurring talk of the euro as an alternative reserve currency. What is important to remember is that this is currently a crisis for the EU and not yet for the EMU. The European Monetary Union is the 12 countries that share a common currency, while the EU includes non-Eurozone countries such as the UK . The euro has very much become a part of the lives of Europeans. The costs of growth and the costs of dismantling the euro and reprinting individual currencies could throw the Eurozone into an even bigger crisis. 

Don't Expect ECB To Lower Rates To Help Dollar
In the second half of the year, the pressure on the ECB to cut rates is even stronger than it was during the first half of the year. Many politicians as well as the IMF have called for the ECB to lower rates to spur growth. ECB President Trichet remain steadfast in his stance that the central bank remains "vigilant and realistic" and is not "preparing the market for any rate decrease."  Many have said that Sweden 's surprise rate cut and the Bank of England's shift in stance will add pressure on the ECB to cut rates. This is highly unlikely though since Sweden is in a very different position than many of its counterparts.  In contrast to the Eurozone, Sweden is facing deflationary pressures.  Annualized inflation fell to 0.2% YoY last month from 0.4% in April.  Inflation in the Eurozone on the other hand was 1.9% last month.  Both countries are facing weak growth of comparable levels and have a 2.0% inflation target.  The numbers alone though tell us that Sweden has a much more pressing reason to lower rates than the ECB.  With oil prices up 29% from May's low, and the EURUSD 7% lower, we will probably see inflation either back or above the central bank's target.  Despite the persistent calls for a rate cut, this will keep the ECB's hands tied for the time being.  The diverging monetary policies between Europe and the US will continue to lend support to the dollar until the Fed shifts back to neutral, after which time we could see the next big move in the dollar.

As time marches on, all good things must come to an end. The last six months have seen the dollar begin to re-exert its dominance once again upon the majors, with the euro breaking the trendline that dominated the price action since middle of 2002.

As the euro continues to tumble, with the latest swing aiming for the 1.2000 figure, a 2004 summer range low, market participants should expect more volatility to be present in the market, a condition that materializes whenever a strong trending market changes its course.

The failure by the single currency to retest its all time high at 1.3667 added to the outlook that the once all powerful euro is losing its dominance.

Key Levels: As time marches on, all good things must come to an end. The last six months have seen the dollar begin to re-exert its dominance once again upon the majors, with the euro breaking the trendline that dominated the price action since middle of 2002. As the euro continues to tumble, with the latest swing aiming for the 1.2000 figure, a 2004 summer range low, market participants should expect more volatility to be present in the market, a condition that materializes whenever a strong trending market changes its course. The failure by the single currency to retest its all time high at 1.3667 added to the outlook that the once all powerful euro is losing its dominance. Enlarge Chart View
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