As the U.S. and Europe are trying to cope with new financial challenges, uncertainty is bouncing from one side of the Atlantic to the other. Currencies are stretched to the extremes and the wind of opportunity appears to be switching again in favour of the Euro against the U.S. dollar. The economic momentum is still running in Europe, despite the incertitude linked to the sovereign debt sustainability, but the upward strength could be limited.
U.S.: Deficit reduction. How would it be done?
The economic recovery stays subdued in the U.S. The housing market is on the defensive, as noted by Mr. Bernanke during his testimonies last week, and represents a major obstacle to the economic process. Both new and existing homes supply is on the rise although mortgage rates are still low. Demand for housing has evaporated along with the expiration of first time home owner tax incentive program, while the economy is failing to respond at most levels. Construction has been flat since January 2009 and the recovery is stagnant. Nonetheless, the weakest sector remains the state and local governments. Since the peak of 2008, they have lost almost 600,000 jobs, about 170,000 in the past six months only.
The fiscal deficit is huge, while the aid provided by the federal government is declining with potentially more job losses this year. Capitol Hill is called for a last minute deal to cap the huge public deficit by U.S. dollar 2-4 trillion over the next decade. Various ideas have been brought to the table. As an example, the introduction of new consumer inflation measure which would replace the canonical Consumer Price Index. Both parties agreed on spending cuts, but a common denominator has to be found yet and the deadline of August 2 is quickly approaching.
Europe, the momentum is still up, but for how long?
Despite the incertitude linked to the sovereign debt sustainability, the European economy stays positive with about 1.8% Gross Domestic Product growth’s prospective this year. In Germany (50% of the European economy), industrial production rose 1.2% m/m in May, after declining 0.8% in April. Domestic orders alone jumped 20%, the widest move since the reunification, while exports were high and supported the trade balance increase to Euro 12.8 billion after Euro 11.9 billion. The European Central Bank (ECB) is keeping a close look at inflation. In fact, with crude oil set to test the high of April again, inflationary pressure will remain above the European Central Bank “comfort zone”. Inflation touched 2.7% in June and is heading toward 3.00%. As a result, rates could again be increased by the end of the year, after the 25 basis points move to 1.50% of July 7/11.
So, as the euro could benefit over the short/medium term of the rate hikes, the U.S. dollar is moving along until the Fed will start to signal the possibility of a rate increase as well. When? A decision could be taken further this year or more probably over the next year and it could eventually help the U.S. dollar over major currencies including the euro. In fact, the longer term picture stays shaky for Europe. Banking and sovereign sectors share a common denominator. Uncertainty flows back and forth undermining both consumer confidence and the economic growth. After Greece, also Portugal and Ireland were downgraded, while Italy just passed a Euro 48 billion austerity package targeted to mitigate the burden within few years. In reality, fiscal tightening has been rejected so far by many nations. Nobody wants to talk about pension cuts or increasing retirement age. However, the term of September 15th for Greece asking new funding is around the corner and Europe might be once more under pressure.
EURO: Supports are holding for now?
Technically, the Euro appears to be preparing a bounce forward that might last between few weeks to few months. The decline of last week did not produce any follow-through. Various levels of support have held and the currency could try to climb again and complete the large head and shoulder formation that started in April. The selling climax of Tuesday, July 12/11, could inspire a rebound to 1.43, 1.45 and eventually 1.50. In addition, seasonal components support the European currency during the second part of the year. November and December could then be two pivotal points. A move below 1.38 would instead take the price to 1.36, 1.34.
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