As expected the European Central Bank left interest rates unchanged at 4.0%. The ECB's views on inflation and growth were not significantly different from those stated at its last meeting on March 6. While the Fed had dissenters at its last meeting regarding its recent interest rate cut, the ECB Governing Council was unanimous in its decision to leave rates unchanged.
Inflation versus Recession
At this time the Fed and the ECB are fighting different battles. The ECB's mandate is to keep inflation in line with its target rate of 2.0 percent. The current rate of inflation is 3.5 percent. Like the Fed, its chief weapon is interest rates. Unlike the Fed, however, the ECB choose to keep interest rates relatively high at 4.0%. Trichet and the Governing Council of the ECB believe that there are upside risks if interest rates are cut. His biggest fear is a hike in wages triggered by higher food and energy prices. He is calling for wage moderation.
The Fed on the other hand has been lowering rates in an effort to prevent a recession. At the same time it has have not to fuel inflation. In addition, the Fed has had to provide enough liquidity to prevent a financial system failure.
Widening Interest Rates Drive the Markets
Fundamentals aside, it all comes down to the interest rate differential. The market is going to seek the highest return. As long as the spread between U.S. rates and Euro Zone rates continues to widen, the EURUSD will continue to trend higher. The same scenario is taking place in the EURGBP. The weakening U.K. economy is going to force the Bank of England to slash rates in an effort to stimulate growth. As this interest rate differential widens, the Euro gains over the Pound.
Although there are going to be short-term breaks in the Euro versus both the Dollar and the Pound, trading the long side is the right way to play the interest rate differential.
Excessive Volatility or a Trend?
In his comments, Trichet also expressed his concerns about excessive volatility in the exchange rate market. I deplore the excessive volatility of exchange rates. I was concerned by the recent excessive moves, he said.
From a chart-watchers perspective, he may be confusing volatility with a trending market. The EURUSD has been trading in a normal higher-top, higher-bottom trend. Traders have committed to the long side because the fundamentals mentioned above have pointed them in that direction. There have not been excessive up and down swings which by most defines volatility.
If Trichet is concerned about the price level of the Euro, then he should just come right out and say that the Euro is overvalued. His comments on volatility put a short-term top in the market on Thursday. If there is going to be volatile counter-trend moves in the Euro, they are going to occur as the result of his comments.
One other reason for his mentioning volatility may be the G-7 meeting today. This may have been his way of telling the G-7 to do something about the strong Euro. Having ignored a request by the IMF earlier in the week to cut rates, Trichet may be trying to get off the hook by nudging the G-7 to take some action. Traders sensing this sold the Euro right after it made a new high versus the Dollar.
How Powerful is the G-7?
With the ECB announcement out of the way and Trichet's comments on the record, the ball has been passed to the G-7. Pre-meeting expectations were for them to announce no intervention plans. They have not intervened since they supported the Euro in 2000. With the pressure put on them by the Trichet volatility comment, the G-7 may issue a statement supporting the Dollar. The short-term direction of the Euro depends on the strength of the statement.
Until there is either a series of weak economic reports in the Euro Zone leading to an interest rate cut by the ECB or an intervention by the Group of Seven, look for the EURUSD to continue to press higher.
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