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Tuesday January 25, 2005 - 21:51:25 GMT -

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Dollar Rises On Improved Confidence

Daily Forex Fundamentals 01-25-05

By Kathy Lien, Chief Strategist

- Dollar Rises On Improved Confidence
- Euro Closes Below 1.30 Once Again
- Yen Weakens Following China’s Comments For No Change at G7


The euro has breached the psychologically important 1.30 level once again following the better than expected US consumer confidence report. At this point, it seems kind of pointless for us to reiterate that the movements in the EURUSD have diverged significantly from fundamentals. Although consumer confidence as measured by the Conference Board improved during the month of January, the extent of the improvement came solely in the present situations component. The expectations component on the other hand, deteriorated. Yet the market chose to focus solely on the positive part of the data, and completely failed to recall the deterioration in the University of Michigan consumer confidence report released this past Friday. The market seems to really want to prove that the euro has topped out and that we may be embarking on a larger downtrend. However, despite recent market movements, we continue to expect the dollar’s downtrend to resume sooner or later. Oil prices are back on the rise, central banks are looking to shift reserve assets from dollars to euros and both the Federal Reserve and the G7 are not expected to make shocking changes to their statement. As such, there are notable levels not far from here that could serve as strong support areas where the euro’s recent trend could reverse.


The US dollar rallied across the board today following a better than expected consumer confidence report. However despite the persistent optimism, we think the party is soon going to come to an end for the dollar. Not only are oil prices just shy of $50 a barrel, the US budget deficit is also at risk of deteriorating even further. Although the White House forecasts a deficit of $427 billion for this fiscal year, the Congressional Budget Office said that it could swell to $855 billion over the next 10 years. With President Bush’s new request for an additional $80 billion to fund the war in Iraq and plans to privatize social security (which would incur initial costs of over a trillion dollars), the market should remain skeptical of the twin deficits reversing anytime soon. Although US officials have acknowledged the need for fiscal discipline, we want to see any specific remedies to directly alleviate this problem before even considering jumping on the dollar bull bandwagon. Meanwhile the quiet period for Federal Reserve Presidents has begun, which means that the dollar will not find any support between now and next week from hawkish commentary.


Although the British pound plunged today, giving back most of last week’s gains it remains in consolidation mode. Like we have previously mentioned, dollar strength is more pronounced in the pound than in the euro due to the abundance of carry traders who are still long the pair and have an increasingly difficult time finding reasons to stay long. The weakness comes ahead of key releases from the UK. Tomorrow we are expecting the first estimate of fourth quarter GDP and the minutes from the January 12-13 monetary policy meeting. Although growth is forecasted to continue at the same pace as the third quarter, the risk is for a weaker release due to the significant deterioration in retail sales during the month of December. As for the minutes, we will be watching to see if more MPC members start discussing the possibility of a rate cut. If so, the pound could face another beating.


Dollar yen was the best performing currency today, rising 1.6% or 182 pips. This newfound optimism was sparked by comments from China’s Head of the National Bureau of Statistics. Dollar yen came under pressure over the past few weeks on widespread speculation that there may be a blockbuster announcement at the G7 meeting by China, but the latest comments from Chinese officials have essentially eliminated the possibility of an adjustment to the Yuan exchange rate anytime in the near future. China’s Li said that the country “doesn't have conditions to adjust the yuan exchange rate at present" and that "we need a good and feasible plan, and formulating such a plan also needs time." Most speculation was thoroughly unjustified anyway, because as we have warned before, China’s financial markets are very immature. In order for changes to the currency regime to occur, not only do local corporations need to be taught how to deal with exchange rate fluctuations, but an exchange or system for appropriate hedging also needs to be readily available. For the past 10 years, the Chinese government has shielded local corporations from the need to worry about changes in the exchange rate. A revaluation overnight would send shockwaves to local exporters. The latest announcement solidifies the 101.70 low as the near term bottom for USDJPY.


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