Euro punishment - view that the ECB is behind the slowdown curve

The ECB held rates firm this week, yet the dollar rallied. The dollar euro exchange rate is now below the levels at the beginning of the year. The current interest differential story states that the dollar should not rally. Rates are more attractive in Europe. Even if the ECB action of no change was expected, it does not suggest there should be a rally unless there is new information in the market.

The story is not in the numbers but the words and expectations. ECB President Trichet admitted that Euroland growth is slowing and action may be necessary. This is a softening of the ECB inflation stand even without a rate decline. The market view is that there is no decoupling story and rates will have to come down in Europe because it will be affected by a US recession. Interestingly, we know that the decoupling story does not apply between the US and Japan, yet we have seen yen strengthening since the beginning of the year. The growth slowdown link is still in place, so the idea of a strengthening euro has been placed on hold. So much for a simple story in FX land.

Of course, the currency is the relative price between two countries so if the ECB and Fed both reduce rates the same rate differential will be in place. If the rate gap remains at current levels, the dollar should be range-bound or lower. However, an alternative is found in the Dec 2008 interest rate futures. The Eurodollar futures is pricing in another 50 bps in Fed cuts while Euribor futures are expecting 90 bps of cuts. The interest gap will actually decline and be more favorable for the US, albeit US rates will still be lower. The currency markets now think the ECB is behind the business cycle curve and does not believe that they will be solely an inflation fighter. That may have been confirmed by Trichet comments.