Euro interest rates to climb in July–and stocks should follow along

Just so nobody thinks he’s going soft, yesterday, June 28, outgoing European Central Bank President Jean-Claude Trichet used the bank’s code phrase “strong vigilance mode” in a press conference in Amsterdam. The language has become the bank’s signal that a rate increase is just down the road. It’s now a virtual certainty that the bank will raise interest rates when it meets in Frankfurt on July 7. The bank’s benchmark rate is now 1.25%.

The European Central Bank raised its benchmark interest rate in April for the first time in three years. But then Trichet disappointed financial markets by not raising rates again at the bank’s next meeting. The pause was understandable—Greece was back in deep crisis mode and the last thing the Greek economy needed was higher interest rates dragging at growth. But financial markets had bid up the euro in a belief that higher rates were just around the corner. When they weren’t, traders sold, sending the currency staggering against the U.S. dollar.

Trichet’s signal and then the actual increase in interest rates on July 7 will reverse that and push the euro back up against the dollar. If euro-denominated assets pay 1.5% (after the July 7 increase) and U.S. dollar-denominated assets pay 0.25% with no chance that the Federal Reserve will raise interest rates until the very end of 2011, if then, investors will buy euro assets and sell dollar assets.

All things being equal, which they never are of course, a weaker dollar will send commodity prices higher. (Commodities are priced in dollars so when the dollar is worth less, sellers of things like oil, and copper, and coffee, ask for more dollars.) That will feed into what is now shaping up as a decent July bounce (and maybe even a rally.)  I don’t want to count my chickens before the Greek parliament votes on them, but if the next days and weeks bring an interest rate increase from Frankfurt and “progress” from Athens, I’d expect to see the current upward bias in stock prices continue for a while.

How long a while?

Last year the June slump was followed by a July to early August rally and then a replay of the slump in late August. In most years July is a good month for stocks, partly due to cash flows from retirement funds. August is the second worst month for the Dow Jones Industrials and Standard & Poor’s 500. In other words the odds favor a replay of last year’s patterns. Enjoy this rally while we have it.

 

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4 comments

• Puttaiah on 29 June 2011

  Thanks for your analysis and providing a clear concept on the matter. But my question is where the U.S dollars stand in the long run?

  Regards,

  Puttaiah
• Cyrus on 29 June 2011

  This post has got me a little confused.
  1. >>> Euro interest rates to climb in July–and stocks should follow along <<>> If euro-denominated assets pay 1.5% ….. and U.S. dollar-denominated assets pay 0.25% ….., investors will buy euro assets and sell dollar assets. <<<

  Aren't US stocks dollar assets? I know that a low US interest rate and weak dollar is good for US stocks, but the above statement seem to contradict the conclusion of the article. Any clarification? Thanks.
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• Cyrus on 29 June 2011

  Looks like the software used for this forum gobbled up part of my posting. I think perhaps it gets confused by “greater than” and “less than” symbols. So I’m reposting:

  1. “interest rates to climb in July–and stocks should follow along”

  Does this mean European stocks, US stocks, or both should climb?

  2. “If euro-denominated assets pay 1.5% ….. and U.S. dollar-denominated assets pay 0.25% ….., investors will buy euro assets and sell dollar assets.”

  Aren’t US stocks dollar assets? I know that a low US interest rate and weak dollar is good for US stocks, but the above statement seem to contradict the conclusion of the article. Any clarification? Thanks.
  -