Trichet Stands Up for the USD

All eyes were on European Central Bank President Jean-Claude Trichet last September 28 as he talked about the state of the euro zone economy before the European Parliament’s Committee on Economic and Monetary Affairs. In his statement, he put emphasis on two important matters: 1) the ECB’s exit strategy and, 2) the importance of a strong USD

On the first issue, Trichet said that it is still premature for the ECB to pull the plug on its stimulus measures. Recall that the ECB has already brought its interest rate to a record low of 1% and has also employed several easing policies to inject more liquidity in their financial market. Despite all these efforts, the euro zone economy is still in a slump as commercial banks remain reluctant to give out credit. The banks’ stubbornness to lend is reflected in the meek 0.1% annualized growth in private sector loans this August. Although Trichet mentioned that the central bank will have to eventually lift its hand from the market, he said, “Sorry folks, it ain’t time for that yet.”

Regarding the USD, Trichet mentioned that a strong dollar is “extremely important” for the recovery of the global economy, especially the export-based euro zone. Market participants have been favoring the euro and the other “anti-dollars” given the broad-based improvement in the global markets.

Still… Trichet warned that the recovery in these economies, particularly in those that rely heavily on exports, may be capped because of the weakening dollar. How so? Note that whenever a country wishes to buy goods and services from a foreign nation, it must first purchase that nation’s domestic currency. This means that, whenever the euro gains versus the dollar, it becomes more expensive for Americans to import goods from the Euro zone.

The most recent euro zone trade balance reveals that its trade surplus grew to 6.8 billion euros, up from June’s positively revised figure of 2.3 billion. Furthermore, the surplus was also much higher than the 1.2 billion euro forecast. Time to pop the champagne, eh?

Ahhh… But first, let’s dig a little further… Notice that these figures are from July, when the EURUSD pair was still trading between the 1.4000-1.4200 range. Since then, the euro has gained a tremendous amount of ground against the dollar and has hit as high as 1.4800. From a broader perspective, the euro has already advanced as much as 15% over the dollar since February.

Looking deeper into the trade balance would show that euro zone’s exports to its top three trading partners – UK, US and Switzerland – have fallen significantly on an annualized basis. Euro zone’s exports to those countries dropped by 27%, 21% and 11%, respectively. Ouch!

Trichet realizes this and knows that if currency traders continue to push the euro higher, the pick-up in exports last July might end up being a fluke.

With Trichet lobbying for a stronger dollar and a weaker euro, the million-dollar question is: Will the markets be on the same page? Dollar strength may take more than mere talk since price action will depend highly on what will happen the coming months. If the euro keeps rising, well, you know how it usually goes… euro strength may end up hurting the euro zone’s exports… which could dampen confidence. This will eventually lead to some risk aversion and the correction that some people are waiting for…

At the same time, we may see the ECB put Trichet’s words into action. Perhaps another rate cut? More quantitative easing?! Take note that the Fed just extended their asset purchase programs to March while the BOE has just added 25 billion pounds to their stimulus. Will the ECB follow their lead?

Of course, we also have to consider the global perceptions for both the euro and the dollar. If concerns over the stability of the dollar continue to escalate, the idea of the euro as a substitute might start to catch on. Indeed, there are a ton of factors that could come into play and we never know for certain how long Trichet would continue to prop up the dollar. Your guess is as good as mine.

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