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Monday January 3, 2005 - 22:46:55 GMT -

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Dollar Strengthens On Stronger ISM and Retracement In Oil Prices

DailyFX Fundamentals 01-03-04

By Kathy Lien, Chief Strategist

· Dollar Strengthens On Stronger ISM and Retracement In Oil Prices
· Manufacturing Activity Improves In Europe
· Futures Traders Flip Back To Net Long Euros


After rallying to a high of 1.3666 through thin trading over the past week, the US dollar has finally managed to garner strength against the euro, helped in part by a stronger US ISM manufacturing survey and a retracement in oil prices. We are beginning to receive data reflecting economic activity globally for the month of November and December. Growth should be the main theme over the first few weeks of 2005, as the data begins to reflect improving activity as a direct result of the 24% decline in crude oil prices since they peaked in late October. The latest manufacturing surveys from Europe provided concrete evidence of the early benefits of the fall in oil. Manufacturing in the Eurozone as a whole unexpectedly accelerated from 50.3 to 51.4, which is the first improvement since July 2004. Across the board improvements were also seen in the manufacturing activity in Italy, France and Germany. The report is optimistic since it suggests that the rise in the euro thus far has had a limited impact on the sentiment of manufacturers. It remains to be seen though whether the rise is simply a reflection of year-end enthusiasm. Meanwhile, the latest CFTC report indicates that futures traders have flipped their net short positions. As of December 28th, traders were net long euros by 16,814 contracts, compared with net shorts of 12,164 the previous week. The rally that we saw last week coincided with the contrarian indication on the report. The latest reversal of positions suggests that the rally in the euro may be losing steam.


The US dollar rang in the New Year on a strong note, as traders back from their holidays assessed the significant rise that the greenback has incurred against the euro over the past week and whether they reflect economic fundamentals. Although the US ISM manufacturing survey improved from 57.8 to 58.6 during the month of December, due to a rise in orders and exports, the employment component of the report was less encouraging, falling from 57.6 to 52.7. With the non-farm payrolls report for the month of November due out this Friday, traders should not remain oblivious to the message that the report may be conveying. Construction spending also declined unexpectedly (-0.4%) in November, however the impact on the markets was minimal since the October report was revised upwards from flat to up 0.3%. For the US, the earlier parts of 2005 should bring good news for growth. Although 2004 brought to us some mixed data on the performance of the US economy, the recovery remains solid, indicating that the Federal Reserve will be continuing on their tightening cycle this year. Oil prices slipped on warmer weather in the Northeast region, which also helped the dollar.


The British pound took a sharp dive despite markets being closed and less pessimistic data released late last week. Unfortunately for the pound, the significance of carry traders makes price action in the pair more prone to sharp swings. House prices should continue to decline in 2005, but as suggested by the latest Nationwide house price report for the month of December, the slowdown should moderate. For the time being, there are no changes to the outlook of the tightening cycle, which has effectively ended. There are reports that the election campaign would begin relatively quickly in the UK. As we have indicated in our 2005 outlook, the outcome of the election (due in May) is a big factor for the pound this year. Although Blair is expected to benefit from an easy victory, a loss for the Labor party would not only mean the loss of Gordon Brown as the UK Chancellor of Exchequer – a man who is considered by the FX market to be the most skilled and effective public policy manager in the world, but also the prospect for higher interest rates under a Conservative party leadership.


The dollar remains under pressure against the Japanese yen, which has benefited from an increase in net long positioning on the IMM over the past week. Net longs increased from 20,576 contracts to 27,753 contracts. On a broader scope, the same problems facing Japan in 2004 will continue to be persistent themes in 2005. The Japanese economy should also benefit from the gradual growth that we expect the US to experience in the early part of this year. Changes in China could have a pronounced impact on the Japanese yen this year. As the restrictions on textile quotas imposed by the WTO are lifted in 2005, China could benefit significantly. However, both the US and Europe will be closely monitoring their exporting activities to ensure that it doesn’t cannibalize their own industries.


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