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Friday February 8, 2008 - 11:55:09 GMT

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Forex Research - Dollar Rally - Just a Counter Trend Move?

Friday, 08 February 2008 11:26:15 GMT

Written by Boris Schlossberg, Senior Currency Strategist

Despite a torrent of bad economic news the dollar has been on a tear this week (see our story Why Is The Dollar So Strong), as the currency market recognized the fact that the slowdown in US economic activity is likely to drag down growth in the rest of the G-10 universe forcing other central banks to adopt a much more accommodative monetary policy.

Talking Points

•    Japanese Yen: Eco Watchers hits a new low
•    Euro: Tries to recapture 1.4500
•    British Pound: Stabilizing at 1.9500
•    US Dollar: Wholesale Inventories on tap


Dollar Rally - Just a Counter Trend Move?

Despite a torrent of bad economic news the dollar has been on a tear this week (see our story Why Is The Dollar So Strong), as the currency market recognized the fact that the slowdown in US economic activity is likely to drag down growth in the rest of the G-10 universe forcing other central banks to adopt a much more accommodative monetary policy.  Already we’ve seen a shift in tone from the BoE which lowered rates by 25bp and issued a statement recognizing “sharp slowing in activity”. Meanwhile, ECB chief Jean Claude Trichet tried to valiantly adhere to  his hawkish bias during yesterday’s post announcement press conference, but the market refused to believe him in light of latest economic data from the region that has shown very steep declines in service sector activity.

Furthermore, a massive rally in long term US yields yesterday caught yen traders completely by surprise driving USDJPY up nearly two big figures. Overnight, yen remained well above the 107 figure as Eco Watchers survey hit a new 10 month low and Japanese Machinery Orders fell –3.2% versus –0.9% expected. 

Nevertheless, dollar’s recent strength may simply be a natural counter trend rally within a long term downtrend move. The key question this year for the currency market will be the relative weakness of US economy versus its G-3 counterparts.  If the deceleration in US growth creates similar woes across the Atlantic, causing a spike in EZ unemployment figures the political fallout from high euro and relatively high interest rates is likely to put enormous pressure on the ECB to begin lowering rates thus eliminating much of euro’s  interest rate advantage.    This week’s 300 point decline in the EURUSD is in effect a bet by dollar bulls that this scenario will soon develop.

However, if the EZ economy is able to weather the slowdown in global demand without seeing any material deterioration in its labor markets,  the ECB may keep rates at 4% for much longer than the market thinks. The Fed in the meantime will continue to lower the Fed funds rate perhaps to 2% by the middle of this year. Yesterday’s weekly jobless claims which printed above the key 350k barrier suggest that the labor situation in the US is rapidly becoming worse. The market therefore may be underestimating the length and the duration of interest rate advantage that the euro may have and once traders appreciate that possibility the EURUSD may resume its upward trek. In the meantime the pair appears to be stabilizing in the 1.4400-1.4500 region and will need to hold these price levels for the next several days to confirm that a near term bottom has been made

Finally, while yesterday’s rally in USDJPY was a short term boost for the greenback, the rise in long term US bond rates may actually prove very damaging to US equities and that in turn could spur another wave of risk aversion pushing USDJPY down to the critical 105 level. In our report yesterday 105 Dollar Yen - Is That Threshold of Pain For BOJ?  we noted that BOJ may be tempted to intervene is the pair gets below those levels. Tonight’s horrid economic data from Japan only re-affirms that idea. Traders therefore should be particularly careful if the pair once again approaches that barrier in the next several days.

Will BOJ Intervene? Join us in the USDJPY forum 



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