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Wednesday May 25, 2005 - 21:33:04 GMT

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Forex: Domino Effect Expected If France Votes No On EU Constitution

DailyFX Fundamentals 05-25-05

By Kathy Lien, Chief Strategist

· Domino Effect Expected If France Votes No On EU Constitution
· Dollar Falls Modestly With Oil Prices Back Above $50
· Yen Gives Back Gains As China Shuns US Demand For 10 Percent Revaluation

US Dollar

Even after having returned to the office from a few days on the road giving seminars, the EURUSD has not strayed far from last Friday’s levels. Looking at the charts, it appears that prices have been contained within a relatively tight range, with no surprising developments here in the US. The only thing that we really need to draw from the FOMC minutes released yesterday is that it confirms what we already know which is that the Fed has full intention of continuing on their campaign of raising rates at a measured pace. According to the minutes, even though all of the governors voted in favor of a rate hike, they did take note that economic data had weakened between late March and early May. This is very important because it clarifies the Fed’s focus. Since the last rate hike, we have had a pretty mixed batch of economic data. Non-farm payrolls and retail sales have been strong, but foreign inflows fell short of the trade deficit funding needs for the same month. Worse yet, the red flags are already waving high for the manufacturing sector. Both the Philly Fed survey and the Empire State survey showed sharp deterioration in May and even though today’s durable goods report rose more than forecasted, the report was far from flawless. If you take out the transportation component, orders actually fell 0.2%. Following the words of the wise, we continue to closely monitor energy prices. In this case, the wise is Greenspan and the words that we are focusing on are his comments last Friday that energy prices “remains central” to the economy’s health. With oil prices back above $50 per barrel, it is no wonder that the dollar has given back some of gains.


Everything seems to be going sour for the Europeans. Not only has the IFO and ZEW surveys fallen short of expectations, but as we close in on this weekend’s referendum on the EU constitution, there is a very viable possibility that the French will be saying “Non” to the new constitution. The worst case though is not just the fact that France could vote no, but that if France does vote no, there could be a domino effect for the votes in the Netherlands, Denmark, Ireland, Poland and even the Czech Republic. A comprehensive no vote by all of these countries could be disastrous for the euro. Yet even though the no camp still commands the lead, with 20% of voters still undecided, the vote could swing either way. Since to many, the immediate fate of the euro seems to be hinging on this one event, it will not be surprising to see a sharp knee jerk reaction after the votes have been tallied. According to a Reuters poll, 85 percent of economists survey expect the euro to sell-off if France rejects the constitution but on the flip side, 92 percent of the same economists also expect the euro to rally if France votes yes on the constitution. Aside from a domino effect, a Yes vote would be very instrumental for paving the way for Turkish membership into the EU. Turkey has said that a no-vote will not derail their plans for EU membership, but even so, it will certainly delay it.

British Pound

The British pound shook off a downward revision to GDP thanks to news of pound positive cross-border M&A flow. Looking first at GDP, it should not be much of a surprise that growth turned out to be weaker than initially estimated, increasing only 0.5% compared to the initial forecasts of 0.6%. This may have been related to the fact that we have recently received a whole bunch of disappointing economic releases including industrial production and unemployment. Yet, the underlying report does show a sliver of hope with personal consumption edging up modestly from the previous quarter. The M&A flow that we are talking about is actually a big one. Warren Buffett announced plans to buy PacifiCorp from Scottish Power for $9.4 billion. Given that over 50 percent of the deal will be in cash, we expect Buffett’s company to be doing a big exchange rate transaction to pay for the deal. If you recall, close to a year ago, Warren Buffett said that US investments are not as attractive as they use to be and that he will also be looking abroad for investment opportunities. Today’s M&A announcement is a perfect example of him doing so and we will not be surprised if more of such cross border acquisitions or investments follow this one.

Japanese Yen

The Japanese yen has given up some of its gains against the US dollar for two primary reasons, namely the rally in oil prices and pared back expectations for Chinese revaluation in the near term. Yesterday, in a detailed proposal to China on how they can fix their problems, the US Treasury has demanded that China start with a 10 percent revaluation. In a near immediate response, China has rejected the Treasury’s proposal saying that, “they will not do this when internal conditions are not ripe, no matter how great the external pressure is.” China did however take measures on Sunday to ease some of the upward pressure on their currency. The State Administration of Foreign Exchange announced a new plan to allow Chinese corporations to invest up to $5 billion a year outside of China, which is a $1.7 billion increase from the previous year. They are hoping that money exiting the country for foreign investment purposes would help to offset some of the massive speculative inflow that is flooding the country for revaluation plays. Even as China tries to push back calls for revaluation, they are examining various options for a more flexible currency regime. According to the Wall Street Journal, “the People's Bank of China has sought advice from private-sector banks, consultants and a number of central banks, including the Hong Kong Monetary Authority, the Monetary Authority of Singapore and the U.S. Federal Reserve, as well as from the International Monetary Fund.” China appears to be particularly interested in Singapore’s managed float regime, which pegs the Singaporean dollar to a basket of currencies. Singapore has kept the weightings of the basket a secret, which has worked well for both the country and its currency.


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