Surprise in currency land -- a strengthening dollar

August is supposed to be a slow month for currency markets with most of Europe on vacation, but the breakout of the dollar so far this month is making for a more exciting August. The euro is at a five month low and the pound is at a 17 month low. AUD and NZD have also fallen markedly. The dollar rally is across the board.

Much of this move is a response to the ECB president's simple words that economic growth is "particularly weak". While the US is ahead of the curve on a slowdown, the focus is now on Europe which has not seen the slowdown to the same degree in the economic numbers. The focus has moved from the higher interest rate differential to a story on economic growth. This is at the same time that rates were held constant and consistent with expectations from survey data. With the slowdown in growth, the focus in on the one-way bet that rates will not move any higher.

So how bad is the European economy? The numbers are clearly moving in the wrong direction. Euro-zone confidence has plunged since last summer. Unemployment is moving up slightly but like the US this is a lagging indicator. Retail sales have fallen 3% yoy and the business climate indicator has moved into negative territory. The PMI services and retail indicators both have moved below 50 which is a sign of a slowdown.

The problem is that there are limited mechanisms for changing this direction in the short-run if the ECB is on hold. The Fed and the federal government through the tax rebate in the second quarter have been more responsive to growth issues.

We have argued that the Fed is frozen and cannot raise rates. Now the ECB may be frozen and cannot lower rates. Businesses and consumers will drive these markets through their behavior in the next few months.