The EUR/USD now finds itself at a critical turning point. Going into the first quarter of 2007, we had said that the divergent growth and divergent interest rates policies of the US and the Eurozone would be the number one driver of EUR/USD price action in the first three months of the year.

Looking back at the charts, we see that the EUR/USD is up 200 points since January 1st, but a closer look at the price action during the quarter reveals that the currency pair saw a far more impressive 500 pip rebound after hitting a low of 1.2944 on January 12th. The dollar’s rally at the beginning of the year was triggered by solid data from the manufacturing and service sectors and the labor market.. However as the EUR/USD consolidated for the rest of January into the beginning of February, evidence of US economic weakness began to emerge. The problems in the US sub prime lending sector exacerbated worries of an oncoming recession triggering the EUR/USD’s ascent to a fresh 2-year high.

Hard Landing, Soft Landing or No Landing?
Looking ahead, the EUR/USD’s ability to challenge its 1.3667 all time high will be dependent upon what type of landing the US economy has - hard, soft or none at all. It is indisputable that US economic growth is slowing but we have yet to see a meaningful housing driven slowdown in the US economy, The sub prime sector is in disarray with more than 30 sub prime lenders forced out of business since the beginning of the year, while large commercial banks such as HSBC have taken a write down of more than $10 billion on their sub-prime portfolio. Yet the Federal Reserve believes that so far the problems have remained contained to the sub prime sector and the data supports that. Even though new home sales increased by the weakest amount in 6 years, existing home sales saw the strongest rise in 3 years. Therefore we can only say that the housing market is beginning to cool and the ripple effects for the rest of the economy have just begun to emerge.

Do not be mistaken, the problems in housing could easily accelerate and this will determine where the EUR/USD is headed next. The manufacturing sector has been shedding jobs for close to a year now, forcing the sector as a whole to teeter on the brink of a recession. The service sector is not faring much better as the ISM reports the lowest service sector reading in 4 years. Meanwhile, the stock market hit a peak in late February while oil prices ran up to $68 in March. This sent consumer confidence tumbling and prospects for a rise in consumer spending along with it. The triple blow of watching their home values fall, their stock market portfolios dwindle and prices at the gas pump rise may be too much for consumers to handle. The only news that they can find comfort in is solid job growth. In the month of March, US corporations added 180k jobs to their payrolls. The Federal Reserve has told us that future actions will be data dependent and so far, none of these problems have become serious enough to warrant a rate cut. However if they do, the Federal Reserve will have no choice but to step in to ease monetary policy. This is especially true if the problems in the sub prime sector spill into prime. Part of the Fed’s mandate is to ensure stability in the banking sector. Alt A lenders that lend to prospective homeowners who are between sub prime and prime are already struggling. At bare minimum, these problems will force all lenders regardless of classification to tighten up their lending standards. In doing so, they will make it much more difficult or more expensive for borrowers across the board. Eventually this could slow demand for homes and push prices lower along with it.

Will Oil Prices Stop the Federal Reserve from Cutting Interest Rates?
One of the biggest hurdles preventing the Fed from lowering interest rates and being proactive at tackling the problems in the housing market is the recent rise in oil prices. Since hitting a low of $49.90 in mid January, crude prices have increased close to 30 percent. Back in 2006, when oil prices hit an all time high, annualized consumer prices in the US accelerated by more than 4 percent. This forced the Federal Reserve to continue to tighten interest rates into the middle of the summer to prove that they could effectively combat inflation. With oil prices above $60 a barrel, the central bank is back on inflation watch. Unless economic growth seriously deteriorates and we see a sharp cutback in consumer spending, they will keep interest rates steady. However if the current correction in oil turns into a more significant reversal, the Federal Reserve will find far more flexibility to react to any further economic slowdown. Interest rates are not expected to be cut in the second quarter, but we may see some speculation begin to build for a rate cut in the second half of the year. This could serve as a turning point for US monetary policy and along with it, the US dollar.

Protectionism
One of the major developments that could hurt the dollar is the US government’s own measures of protectionism. For the first time in 23 years, the Commerce Department has announced that they will be imposing tariffs on paper imports from China. After having waited over a year for another major revaluation move by the People’s Bank of China, the US has decided to take things into their own hands in late March. Although details have not been fully disclosed, the government is expected to impose penalties in range of 10.9 to 20.4 percent on imports of glossy paper from China. The impact of tariffs on glossy paper imports is small, but the initial win for Congress will make it easier for tariffs to be imposed on other imports such as steel, machinery and furniture which represent a far larger portion of overall US trade with China. The Chinese are angry about the decision and they are demanding that the US reconsider or else they reserve "the right to take any necessary action" in response. If China decides to retaliate by diversifying some of their big war chest of foreign exchange reserves away from the US dollar, the biggest beneficiaries would be currencies such as the Japanese Yen, Euro and British pound. This could force other foreign investors to veer away from dollar denominated investments, especially after they bought dollars so strongly back in January. Of course, this turn in investment demand would more likely be sparked by a shift in US monetary policy than a trade war.

Eurozone Rates to Peak at 4.00%?
On the other side of the Atlantic, the European Central Bank may be nearing the end of their tightening cycle. After having increased interest rates by 175 basis points over the past 16 months, another interest rate hike is still expected in the second quarter given recent strength in economic data. At the beginning of the year, the market expected the rise in the Value Added Tax in Germany to have a big impact on the German economy. Instead, it only pushed consumers to spend more aggressively in the month of December and this spending continued into the beginning of January when falling oil prices offset the strain of higher taxes. This explains why in the first two months of the year, when we had December and January data come out, there were a great deal of upside surprises. Business confidence and economic growth was exceptionally strong as consumer spending accelerated by 3.2 percent in the month of December. However since December, spending has not been as hot. In fact, German retail sales dropped by 4.3 percent in the month of January and rebounded by only 0.9 percent in February. Yet we have not seen much signs of slower growth besides consumer spending. Activity in both the manufacturing and service sector continues to expand in March, while factory orders and industrial production increase in the month of Feb. The labor market is improving in both France and Germany as the German unemployment rate dips from 7.4 percent to a six year low of 6.9 percent. Business confidence rebounded in March, confirming that even though we are beginning to see the impact of the VAT tax increase, it has been limited.

Comments from European Central Bank members have also been very hawkish. The ECB has long been a central bank that prefers to reduce volatility in the markets by preparing the markets for a rate change months in advance. Going into the second quarter, ECB President Trichet and the members of his monetary policy committee have been staunchly hawkish due to inflation risks. In early April, Trichet said that “In the opinion of the ECB Governing Council the outlook for price developments in the medium term remains characterized by upside risks…Every observer, investor, every saver, in Europe and the rest of the world, knows that we will do what is necessary to ensure price stability.” Basically, he is telling us that they have full intentions of taking Eurozone rates to 4.00 percent.

However their next interest rate hike is expected to be their last as the sharp rise in the Euro over the past few months may force the ECB to reconsider raising rates beyond 4.00 percent. A rising Euro automatically tightens the economy and reduces inflationary pressures. As we get closer to the EUR/USD’s 1.3667 all time high, the more strain the strong currency will put on the export dependent economy. Remember our saying; the path to a stronger Euro is through a weaker one. Along those same lines, the path to a weaker Euro is through stronger one.

French Elections Could Hurt the Euro
On April 22 of this year, France will go to the polls to select her next President. Although the field is crowded with 12 candidates, the French electoral process quickly winnows down the choice and then produces a second runoff election between the two topmost vote getters on May 6th of 2007. Amongst the 12 hopefuls only three candidates stand a realistic chance of moving up to the second round – the Socialist Ms. Segolene Royal, the centrist Mr. Francois Bayrou and the center right choice, Mr. Nicolas Sarkozy. At present, Mr. Sarkozy enjoys a comfortable lead over his opponents and appears to be shoe-in for the second round of voting. Typically, a free-market, center right candidate like Mr. Sarkozy would be welcomed by the FX market with open arms. But this being France, the election has become a much more nuanced and problematic matter for currency traders around the world. The issue? Mr. Sarkozy’s very vocal dissatisfaction with the restrictive monetary policies of the ECB and his advocacy for a weak Euro. On March 19th Mr. Sarkozy stated, “Competition is such with globalization that we don't need to fight inflation like we fought inflation 30 years ago. I want the Europeans to be able to do with the Euro what the Americans do with the US Dollar, the Japanese with the Yen and the Chinese with the Yuan (i.e. use their powers to influence exchange rates). …We are depriving ourselves of an instrument to create growth, provide jobs, for purely ideological reasons. Well, the Euro doesn't belong to Trichet…and I'm not the only one in Europe who thinks so.” A victory by him could be seen as Euro negative, but in the long run, we expect Trichet to stress the central bank’s independence, a move that will indicate that Sarkozy’s comments is more bark than bite.

Conclusion
As the currency market enters the second quarter of 2007, the main driver of the price action in the EUR/USD will be determined by the depth any housing market downturn in the US. If the problems in the sector are contained only to sub prime mortgages, then the Federal Reserve may keep interest rates unchanged at 5.25 percent, which will spur continued demand for dollars. If, at the same time, the ECB signals an end to their tightening cycle, it could exacerbate any moves lower in the EUR/USD. On the other hand, if US consumer spending contracts significantly as a result of a more major downturn in the housing market, then the Federal Reserve may have no choice but to deliver the rate cut that the market has been anticipating. In that case, we could see the dollar head to fresh lows against the Euro.

Technical EUR/USD Outlook
The EUR/USD hit two year highs in the first quarter of 2007 after taking out the December 2006 high of 1.3364. For the time being, the December 2004 all-time high at 1.3666 remains intact. The decline from 1.3666 to 1.1638 took 47 weeks and the advance from 1.1638 is 73 weeks (so far). It is significant that the rally has yet to reach the December 2004 high and that the rally has taken significantly longer than the preceding decline because these are the characteristics of a correction. In other words, the entire rally from 1.1638 is a correction of the decline from 1.3666 to 1.1638. Also, the rally from 1.1638 is 1.55 times longer in terms of time than the decline from 1.3666. A nearly perfect 1.618 Fibonacci ratio would occur at 76 weeks (76/47 = 1.617) and the 76th week is the first week in May. Form also favors a top and reversal. The chart below shows that the decline from 1.3666 traced out a clear 5 waves down (impulsive). The rally from 1.1638 is in 7 waves which divides into a complex correction known as a double zigzag. A double zigzag consists of two A-B-C corrections joined by an X wave which is labeled W-X-Y. The first a-b-c forms the W and the second a-b-c forms the Y. Further, the last two significant highs (1.3364 and 1.3439) have not been confirmed by weekly oscillators (bearish divergence). Speculative positioning, as reported by the CFTC (COT report), remains near record levels as well. A break of 1.3666 does not necessarily invalidate a reversal scenario. In fact, wave Y would equal wave W at 1.3799. Looking back further, the rally from the October 2000 low (.8227) to the December 2004 high is clearly impulsive and in 5 waves, thus the very long term trend is up. However, since corrections unfold in 3 waves, a 3 wave correction (A-B-C) should unfold from 1.3666. So far, there is one leg down (to 1.1638) in what is wave A and another leg up (present) in what is wave B. Wave A and B possess the proper characteristics as well, with wave A impulsive and wave B corrective. We expect wave C to begin soon and eventually draw price under 1.1638 (albeit in 40-50 weeks). Coming under the January low of 1.2865 would indicate that we are on the right track. Watch for support at the long term trendline near 1.2700/50 as well. There are alternate counts which we’ll present if price action dictates. In summary, the EUR/USD may chop higher but the risk of a violent reversal is high.



Kathy Lien is the Chief Currency Strategist at FXCM.