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Wednesday December 22, 2004 - 22:18:44 GMT -

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Dollar Remains in Range Against Euro As Holiday Lethargy Sets In

DailyFX Fundamentals 12-22-04

By Kathy Lien, Chief Strategist of

· Dollar Remains in Range Against Euro As Holiday Lethargy Sets In
· Pound Slides As Bank of England Bias Increasingly
· Yen Shows Strength on Trade Data


Price action the EURUSD has narrowed to a 64-pip range over the past 24 hours, making trading incredibly boring. For those enthusiasts who are still in the markets, tomorrow’s heavy economic calendar could provide a brief period of interesting trading, as the US is slated to release data that would give insight into how the economy performed in the fourth quarter. Most likely though, unless there are any significant shocks in the releases, most traders will be closing their books and leaving early for the holidays. The ranges however, are moving closer to the all-time high, signaling that an upside breakout may be in store in the New Year. There is also other evidence that supports this observation. As we have previously discussed, speculative positioning has turned net short euros on the IMM. The latest FXCM Speculative Sentiment Index also indicates that net short positioning in the euro is growing. This means that when the market returns in full force next year, the dollar should continue to weaken since the problems of 2004 will still be problems in 2005. Exchange rate overshooting could also be problem as positions are being rebuilt in January.


Even a surprise upward revision to the final third quarter GDP report from 3.9% to 4.0% failed to rally the US dollar. A smaller increase in imports, which subtracts from GDP helped the economy grow by more than expected in the past quarter. Since the second quarter of 2003, quarterly growth in the US has averaged a highly respectable 4.58%. This compares to a paltry 0.37% average quarterly growth for Europe during the same period. With the Fed expected to continuing raising rates next year and the ECB restricted from altering monetary policy, it leads many to wonder if the current account deficit, which has been with us for over 10 years now, really warrants so much focus by the markets. Unfortunately, it does. It has been a problem that the US has able to get away with for some time. However, record highs in the deficits and waning funding by international investors is making it an even more concerning problem. The Fed is using the weaker dollar as a tool to fix the real problem behind the current account deficit, which is that US consumers are spending too much and saving too little. The national savings rate has been averaging 1.5% of GDP since 2002. With real short-term rates (libor rate – inflation rate) barely above zero and nominal long-term rates, there is little incentive to save. Instead, US consumers have chosen to snap up real estate, causing fears that a bubble may be developing. Soaring prices of homes have built up the paper wealth of consumers, giving them an even further incentive to spend. The Fed’s game plan is to encourage a weaker dollar, which would spark inflation and give them justification for raising rates more aggressively in 2005. Higher rates promote savings by increasing credit card interest payments and mortgage payments, but it also crimps the paper wealth of consumers by pushing asset markets valuations such as real estate prices lower – all of which lead to a narrowing of the deficit.


The British pound extended yesterday’s sharp losses following the release of the minutes from the December 8-9 monetary policy meeting. According to the minutes, some members of the bank thought that, "the downside risks to the inflation projection had increased but not enough to make a persuasive case for a reduction in interest rates.” Weaker growth in Europe and Japan and a rise in the sterling prompted at least two members to bring up the possibility of a rate cut. None of the members discussed the possibility of another rate hike. Therefore even though the central bank is clearly on hold and not likely to reduce interest rates soon, their bias is becoming increasingly dovish. Unlike the EURUSD, the GBPUSD has historically been an attractive currency pair to go long for carry trades due to its relatively higher interest rate differentials. Therefore, whenever there is news that can threaten or narrow this differential, the pound suffers from volatile moves as speculators rush to exit positions.


The Japanese yen rallied against the dollar today, fueled by stable trade data. Last night’s merchandise trade report showed that Japan was able to hold on to their trade surplus despite the stronger yen. Exports increased 13.4% from last year, slightly lower than economists’ estimate of 16.8%, and are expected to remain on this track. Even as steel prices climb, export volume has still managed to rise 18.5%. The fact that the magnitude was ¥602B, much lower than the median forecast of ¥970B, may have limited the yen’s advances. However, on a seasonally adjusted basis, November’s trade surplus was ¥990.5B, which is actually an improvement from October’s ¥852.1B. In terms of the services industry, yesterday’s release of the tertiary index indicated a 0.1% decline from September. Most of this is attributable to the typhoons and earthquakes that hit Japan in October. The index is expected to improve as consumers spend more on travel and restaurants during the Christmas season.


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