Euro May Chart Its Own Course

MarketWatch.com, August 3, 2005

CHICAGO (MarketWatch) - A series of political and economic events in recent weeks may have finally put the near-term course for the euro in the hands of Europeans, the common currency's fate no longer necessarily at the mercy of dollar moves.

Of course, currency exchange is a two-way street and dollar developments will continue to guide trading. But for the first time in a long time, European economic data are moving the euro while U.S. data are having, at best, a cursory influence on the buck.

Take Wednesday: the euro sailed to two-month highs in part as a euro-zone measure of the services economy showed expansion, edging up to 53.5 in July from 53.1 in June. A U.S. services measure also showed expansion on Wednesday, even more so than Europe at over 60 for July, although at a slower rate of growth than in June. The dollar got no relief.

With the data covering the Continent (and the United Kingdom too) improving and expectations for a European Central Bank interest-rate cut all but dead, further strong data out of Europe have favored European over U.S. yield spreads, wrote Action Economics currency analyst Jon Coughtrey.

Relative calm on the political front, after heavy mud-slinging earlier this summer over the European Union constitution, has also restored confidence in the euro.

A dollar-bullish U.S. interest-rate advantage, Chinese currency revaluation uncertainty and even the ongoing dollar tug from a persistently wide U.S. trade gap are factors that have yanked the euro around, evan as the euro-zone economy sputtered along, largely uninspiring to investors. The euro rallied to multi-year highs against the dollar late last year only to fall some 10% in the first half of this year.

In fact, a weaker euro and its benefit to exporters was largely responsible for the economic bottoming that many see in place.

Pro-euro sentiment is spreading.

Rumors circulated among trading desks Wednesday of Saudi Arabian and Kuwaiti buying of euros, enough to set the common currency on its higher trajectory Wednesday.

Expensive oil once was linked to a strong dollar since global oil is priced in dollars. That may no longer be the case.

Data from the European Central Bank showed that OPEC and former Soviet states are spending a growing share of oil proceeds in Europe, thus converting dollars to euros. Oil above $60 a barrel will only boost revenues.

OPEC-related buying of euros "is nothing new," stressed Jason Daw, forex strategist with Merrill Lynch, covering the Group of 10 largest industrialized nations.

Daw cites Bureau of International Settlement's data that show OPEC exporting nations have been shifting dollar proceeds into euros regularly over the past two years.

Add into the mix Russia's decision this week to up the share of the euro in its two-currency basket used to determine day-to-day market operations to 35% from 30%. The dollar share thus falls to 65% from 70%.

Even debt repayment has a euro-positive spin. Substantial Paris Club repayments by Russia this week, repaid in euros, boosted demand for the currency.

Daw chalked up the euro's charge to thin conditions as currency desks clear out for summer vacations. A lack of liquidity makes currency transactions like reserve shifts and OPEC conversions have a greater impact.

But the factors are stacking more in favor of the euro.

Merrill Lynch thinks the euro could be back near $1.32 by the end of the year.

Brian Dolan, head of research with retail currency trading firm Gain Capital, agrees that a shift toward euro buying is having a larger impact in thin seasonal conditions.

Central bank currency buying is a controlled, technical exercise usually telegraphed after the fact. Its long-run impact is limited, says Dolan, shy of an all-out rotation in reserve holdings out of the dollar into the euro.

He sees recent euro demand more as a factor to prevent the dollar from strengthening rather than a sign of new life for the euro. Euro-zone interest rates after all stand at 2% to the Fed's 3.25% - and rising - target.

Dolan thinks the euro will put in a bottom against the dollar at $1.20.

The next big test for the currency market will be Friday's U.S. jobs report, traders said.

Limited dollar reaction to a satisfactory gain in payrolls will likely assure investors that the U.S. economy is no longer the driving story in the currency market.