Captain of our fairy band,
Helena is here at hand,
And the youth, mistook by me,
Pleading for a lover's fee.
Shall we their fond pageant see?
Lord, what fools these mortals be!
- A Midsummer Nights Dream Act 3, scene 2
It is said that markets discount the stuff we do know and run on the stuff we don’t. Let’s take a look at what we do know, might know, and some best guesses about the future (called forecasts by “serious” analysts), as it relates to the rally in EUR/USD:
1. Euro short rates relative to the US have turned higher again, i.e. the yield differential in favor of euro is improving.
Question: Will this continue?
Best Guess: I don’t think so because euro supply may begin to overwhelm demand (see #2 below). And if US growth is for real, and a the 10 nation Eurozone recession is for real, one would expect US 3-month benchmark rates to drift higher relative to the euro.
2. European Central Bank expected to flood banks with more credit next week; euro seemed to rally sharply on the last round of Long-term Refinancing Operations (LTRO) by the European Central Bank, i.e. three-year term loans to the European banking system.
Question: Will we see the same type of rally in the periphery debt this time around?
Best Guess: Unlikely, in fact it might be a good time for those who bought last time to sell into the next round of ECB Long-term Refinancing Operations. If so, if the EUR/USD rally shows signs of stalling next week, it could be time to start looking the other way.
3. There is a lot of Fed jawboning about the potential for QE3.
Question: Is QE3 baked in the cake?
Best Guess: I don’t think so. Two points here: 1) If the US recovery is for real, it doesn’t make sense that Fed Governors are so boisterous about the potential for QE3; and 2) Even Ben Bernanke (going out on limb here) has to understand that monetary policy stimulus has limits that become counterproductive at some stage and many, including me, think we are into the counterproductive territory. Plus, how will QE3 that sits on US banks' balance sheets help any more than the pledge to hold Fed Funds rates low into 2014, in and of itself an incredible act by a central bank chief? It is what a rational person, assuming Ben is rationale, may ask himself.
Bottom line: Though the recent move in EUR/USD is powerful, I think it is a relatively near-term event. Here’s why: 1) If the US is really growing, the dollar at some point wins on growth and yield relative to euro. Growth and yield are the intermediate-term drivers for currencies, and 2) if the US goes back into recession, a case we made in our latest Global Investor monthly issue; Europe goes into an even deeper one and China is in trouble too. This means the US dollar, for all its warts, gets a big risk bid.
We watch and see how reality plays out against our best guesses ...