Sunday, December 17, 2006

Maybe the euro isn't really staging a true breakout

Although there was a huge amount of chattering about the renewed strength of the euro as it moved from about $1.28 to $1.33, now most of the excitement has completely died off.

It is still very unclear whether the move was a one-time adjustment, speculative activity driven by strictly technical considerations, or maybe even the start of a true upwards move. We may have to wait a month or two to get a solid answer. The problem is that there is so much excess liquidity in the world right now that even a moderate shift can cause significant asset and foreign exchange spikes. Worse, even a very modest shift can snowball into a larger spike due to a piling-on of speculative capital.

The euro has now pulled back from the recent peak and may fall back into its old trading range unless there is a significant ongoing shift of capital from U.S. assets to Euro assets. But, with some renewed belief that the U.S. economy is not really falling off a cliff and that the Fed might actually raise rates rather than lower them, the U.S. could in fact gain from assets seeking higher returns, even if there has been a short-term shift to Euro assets.

My original suspicion remains that that the exodus from dollars was driven in large part by an expectation that the Fed would be cutting interest rates within a few months. But as that rate-cutting expectation continues to evaporate in the face of better-than-expected economic data, money flows could reverse at least somewhat and flow back into dollars.

-- Jack Krupansky

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