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Friday August 15, 2008 - 00:46:46 GMT

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FX Blog - US Dollar Breaks Through Key Resistance As US CPI Hits 17-Year High -€“ Rally Likely to Continue

• US Dollar Weakens As Retail Sales Fall Negative – Will Inflation Data Revive the Greenback?
• Euro Drops Below 2007 Highs As Q2 GDP Contracts, CPI Holds Steady
• British Pound Consolidates Huge Losses as Markets Price in 75bps Worth of Rate Cuts

US Dollar Breaks Through Key Resistance As US CPI Hits 17-Year High – Rally Likely to Continue
The US Dollar index finally managed to rise above critical resistance from a falling trendline connecting the late 2005 – 2007 highs, indicating that the currency’s rally is not over quite yet. However, according to the latest forex positioning figures, traders are growing less bearish on the greenback, and as a contrarian indicator, this means the currency is likely to consolidate near current levels. What happened to trigger the jump in the dollar? US CPI hit a 17-year high of 5.6 percent in July, which was significantly higher than expected and was driven by food and energy cost gains. Meanwhile, core CPI edged up to a 17-month high of 2.5 percent. However, the greenback’s reaction was delayed, and we’ve actually seen that interest rate expectations – as measured by Credit Suisse overnight index swaps – haven’t changed very much, as they are still pricing in 75bps worth of rate hikes within the next 12 months. Indeed, the markets are already well aware that downside growth risks and upside inflation risks plague the US economy, but given the persistent instability in the financial markets, the Federal Reserve really has little room for maneuver and will likely leave rates unchanged at 2.00 percent until 2009. Indeed, financial institutions are not out of the woods yet, as the central bank continues to hold auctions at least twice a month for credit through its Term Auction Facility (TAF), which was started back on December 12, 2007, and demand is consistently higher than the offered amount. In fact, the latest auctions for $25 billion in 84-day credit and $50 billion in 28-day credit saw over $130 billion in propositions submitted. Given the fact that the program is still running after 8 months, liquidity has obviously not been fully restored and with the credit crunch still lingering, the Federal Reserve has no room to raise rates anytime soon.

Euro Drops Below 2007 Highs As Q2 GDP Contracts, CPI Holds Steady
The Euro remained heavy on Thursday as Euro-zone GDP contracted 0.2 percent in Q2, dragging the annual rate to a more than 3-year low of 1.5 percent. This is only the initial estimate of the reading so a breakdown is not available, but the latest PMI reports for the services and manufacturing sectors have signaling a contraction in business activity, signaling waning domestic and foreign demand. Meanwhile, Euro-zone CPI unexpectedly held steady at an annual rate of 4.0 percent. While this is still well above the European Central Bank’s 2.0 percent target, the fact the index didn’t accelerate faster was enough to lead the markets to become more aggressive in pricing in a rate cut by the central bank within the next 12 months. This shift in sentiment, where traders are expecting rate cuts by the ECB and rate hikes by the Fed, puts the odds in favor of additional EUR/USD losses in coming weeks.

British Pound Consolidates Huge Losses as Markets Price in 75bps Worth of Rate Cuts
There were no economic releases on hand for the British Pound on Thursday, but lingering sentiment from Wednesday’s BOE Quarterly Inflation Report was enough to continue weighing on the currency. Indeed, the central bank offered a bleak picture of UK economic conditions, as they revised their growth projections sharply lower for 2008 – 2009 and even said that GDP could be negative for one or two quarters. Meanwhile, the markets have shifted to price in more aggressive rate cuts by the BOE over the next 12 months, as Credit Suisse overnight index swaps are now pricing in almost 75bps worth of cuts compared to 50bps just a few days ago. The odds are against the BOE, but we believe that the central bank will not move to cut rates until 2009 as they try to allow the UK’s economic slowdown to bring down inflation pressures. In the near-term, GBP/USD is likely to continue consolidating above the recent lows at 1.8650, but I still believe that the pair will ultimately move down for a test of 1.85.

Commodity Dollars Struggles To Hold Onto Latest Gains
The Australian Dollar, New Zealand Dollar, and Canadian Dollar all struggled to hold on to Wednesday’s gains amidst choppy trading, as commodities like gold and oil ended the day lower. However, gold has now fallen for 9 of the past 10 trading days, suggesting that a bounce may be in store for the metal and commodity dollars alike. Meanwhile, New Zealand retail sales were better than expected in June, as the index jumped 0.9 percent. However, the Q2 reading that excludes inflation fell 1.5 percent, marking the second consecutive quarter of contraction. Nevertheless, in the longer-term, there is still significant downside risk for Aussie, Kiwi, and the Loonie. Consequently, rallies in these currencies should be seen as selling opportunities.

Japanese Yen: Still Mixed Across the Majors, Upside Risk Remains for the Low-Yielder

The Japanese Yen ended the day lower against the greenback and British Pound but rallied against the rest of the majors, as the markets remain jittery. Indeed, the DJIA saw extremely choppy trade as the index opened lower, but subsequently ended the day nearly 100 points higher. However, as we mentioned above, the financial markets remain very unstable, and traders should continue to keep an eye on technical levels and risk sentiment, as the Japanese yen tends to trade based on these factors rather than fundamentals.

South African Rand, Turkish Lira End Day Slightly Higher As Central Banks Leave Rates Steady

Both the South African Rand and Turkish Lira edged slightly higher against the US dollar on Thursday as the South African Reserve Bank (SARB) left rates steady at a five-year high of 12 percent following six hikes since last year, while the Central Bank of the Republic of Turkey left rates at 16.75 percent after hiking during the past three meetings. Indeed, both regions have experienced robust price growth, but with domestic demand starting to wane, they will seek to take less aggressive actions going forward. On Friday, Banco de Mexico is expected to raise rates by 25bps to 8.25 percent, but as usual, the reaction of USD/MXN will depend greatly on the central bank’s subsequent policy statement. For more in-depth analysis of the South African Rand, Turkish Lira, and Mexican Peso, check out our Forex Emerging Markets Weekly.

For coverage on the Hong Kong Dollar and Singapore Dollar, check out John Rivera’s Asia Emerging Market Daily.

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Written by Terri Belkas, Currency Strategist for

E-mail: [email protected]


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