Pundits and Pendulums: Market Overreactions
October 26th, 2006 by Justin
Central bankers, especially in the US and Eurozone, try to be as methodical as possible. The market, however, tends to overreact to near-term news and get out of line with real central bank expectations. Weeks ago, the markets had priced in that the Fed would not hike again, and might even pause prior to the end of 2006. That was an overreaction causing false dollar weakness. Days later, as the USD gained strength, interest rate futures and pundits were predicting that a “pause” really would be only a “pause” prior to another rate hike from the Fed. This caused excessive dollar strength.
Now, the market is starting to overreact in the same way to the ECB’s likely movements. As the euro gains strength and everyone jumps on the bandwagon, the market–which only days ago was starting to doubt that the ECB would hike again this year–is now pricing in a high likelihood of two hikes by early 2007. It’s not completely out of hand yet, but if the EUR/USD pushes above 1.2750 or so, it’s very likely we’ll see the pendulum swing back in favor of the dollar and see the hopes of those expecting multiple ECB hikes dashed.
