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Wednesday March 16, 2005 - 23:03:33 GMT -

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Euro Rallies As Ukraine Drops Dollar Peg And Shifts To Euro Basket

DailyFX Fundamentals 03-16-05

By Kathy Lien, Chief Strategist of

· Euro Rallies As Ukraine Drops Dollar Peg And Shifts To Euro Basket
· Dollar Reverses On New High In Oil And Wider Current Account Deficit
· UK Labor Market – Still The Best Out There


The euro’s rally is back on track as the single currency completely erased yesterday’s losses. As we had mentioned in our previous report, the blowout TIC number failed to have much underlying strength and based upon today’s report, it seems pretty clear that other traders are jumping on our bandwagon. Its all about reserves these days – Ukraine announced today that they will be dropping their dollar peg and adopting a basket exchange rate that includes the euro. Although Ukraine is a relatively small player in the US Treasury world, what they are doing is an exhibition of what may be going on in the heads of other central bankers. With 42% of their trading activities conducted with the 25-member EU, it is logical that Ukraine has a vested interest in diversifying its reserves. They plan on raising the euro component of their reserves to 25%. The Ukraine is the latest country to join the reserve diversification craze. South Korea, Japan, Russia and even China to some extent are displaying waning demand for dollar denominated assets. Reserve diversification does not happen overnight and none of these central banks can afford a dollar crisis, yet this shift in official sentiment towards US treasuries is certainly alarming. Meanwhile across the Atlantic, ECB Trichet helped to fuel the euro’s rally with upbeat comments on growth. Eurozone headline inflation also beat the flash estimate, rising from 1.9% to 2.1% yoy in the February. This has resulted in some mild speculation circulating around the markets that the ECB may deliver a rate hike towards the end of this year.


The dollar weakened as the US current account deficit widened to $187.9 billion from $165.9 billion. Although the current account deficit is backward looking (as of Q4 2004), the newswires seem to be latching onto the wider deficit as the cause for the dollar’s slide. However, we prefer to attribute the dollar’s slide to new record high in oil prices. Oil hit a high of $56.60 per barrel, despite an announcement from OPEC that they plan on raising quotas immediately by 500k barrels a day. A report from the Energy Department indicating a larger than expected fall in gasoline inventories brought bears out in full force. Even though OPEC increased quotas, most countries were over-producing anyway, which means that additional output may not be seen until May. Furthermore, the summer season (beginning as early as Memorial day weekend) tends to see a sharp rise in the demand for gasoline with many families taking road trips. However, not all news was bad news for the dollar. Housing starts soared to a 21-year high indicating overall strength in the US real estate market. Industrial production was mixed, it increased by 0.3%, which was less than expected, but the output number in January was revised higher as well.


There was a nice rebound in the British pound today on stronger labor market data. The number of unemployed individuals increased by only 700 people. Imagine that! With a population of 60 million people, there were only 700 more people who lost their jobs in the month of February. With these sorts of numbers, we can see why the UK’s economy is the envy of the world. The level of employment remains at a record high and wages including bonuses increased 4.40% in the month of January. Meanwhile, Chancellor Brown delivered his 2005 budget today. He was upbeat on the economy, offered up temporary tax cuts and an increase in benefits, which is surely an election play. The election is scheduled for May 5th, which is right around corner. Thanks to higher oil prices helping to boost oil tax receipts, the UK’s temporary GBP1.25 billion tax cut to households in 2005/06 is completely paid for and leaves the projections for public sector net borrowing generally unchanged.


Overall, trading the dollar against the yen has been fairly uninteresting. Ranges continue to contract as the Japanese yen strengthened against the US dollar, which comes in contrast to weaker leading economic indicators and higher oil prices. Yet, as the ranges contract, the case only continues to build for a breakout scenario, so yen traders should watch out for the explosive move that may be brewing. As expected, the Bank of Japan made no changes to monetary policy. They did however upgrade their economic assessment modestly. In his comments following the meeting, Governor Fukui reiterated the central bank’s belief that deflation has not been wiped out and that the government needs to continue making efforts towards that goal. Based upon these words, they still want to keep policy accommodative until inflation is in a consistent upward trend. Data on consumer prices are expected next week. Prices slipped once again in the month of January after having increased for three consecutive months. We believe that the BoJ wants to see at least another one or two months of increasing prices before tweaking their reserve target.


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