Correlations in currency markets are never permanent, even in the best of times.
And with interest rate outlooks starting to shift, the correlations that have recently ruled the euro and the dollar are likely to break down.
This means the dollar will fail to benefit much from stronger U.S. data and that the euro’s response to any debt crisis solution will be disappointing.
First, let’s look at the dollar.
The U.S. economy may still be languishing by many measures, but stronger-than-expected GDP growth in the third quarter, and a string of very positive numbers since then, suggest the U.S. is doing a lot better than other major economies in Europe as well as in Asia.
In fact, it could be seen as the only real bright spot in the global economy.
But this isn’t translating into a strong dollar. After reaching a recent high in early October, the dollar index has traded at lower levels.
The Fed can be blamed for that. Officials have made it clear that, despite the data, easy monetary policy is here to stay for a while. And it may even get easier. It just depends on what impact the economic slowdown and the threat of recession in the euro zone has on the U.S.
If you are at Morgan Stanley, you probably take the view that the U.S. economy is closed enough to be largely immune. The bank’s head of global foreign exchange strategy Hans Redeker reckons that as long as U.S. money supply and lending data remain healthy, the spillover from the euro zone should be minimal.
If you are at Commerzbank, however, you will probably be taking the opposite view.
“At present concerns in the U.S. about the effects of the European crisis on its own economy are likely to be so high that this alone increases the likelihood of QE3–a further round of quantitative easing,” said the bank’s currency strategist Lutz Karpowitz.
So, no matter which way you look at it, strong U.S. data does not mean a strong dollar. Unless of course, the data goes off the scale!
The other side of this is the euro.
For some time now, despite all the ups and downs of the debt crisis that still threaten to destroy the currency, the euro has generally benefited when the global investment community has been prepared to take on risk.
But as the euro zone recession starts to bite and inflationary pressures subside, the European Central Bank will be under pressure to introduce its own version of quantitative easing, Some are looking for the bank to shave interest rates again at its meeting next week.
As speculation rises that the ECB is now going down the same road as the Fed and the Bank of England, the correlation between the euro and risk will break down, leaving the single currency more at risk from expectations of monetary easing than from hopes of an early solution of the euro zone debt crisis.
