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Monday August 22, 2005 - 21:41:22 GMT

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Forex: Euro Surges on Sharp Increases in Capital Inflow

DailyFX Fundamentals 08-22-05

By Kathy Lien, Chief Strategist of

· Euro Surges on Sharp Increases in Capital Inflow
· Dollar Loses Value as Economists Predict Oil Induced Contraction in Growth
· Yen Rallies as Koizumi Gains in the Polls

US Dollar

The dollar has lost ground against the euro, which comes as no surprise to those of us that are watching the markets with only a mild interest. Last week the markets were very quiet with range trading being the predominant theme. We expect this week to be no different. With not much to talk about, economists and market watchers have only 2 things on their mind – which is oil and real estate. There continues to be more signs of a housing market slowdown in the hot areas such as California and Florida. No one is really calling for a widespread collapse, but a collapse is not necessarily needed to have a big impact on US consumption. It is the mere realization that the housing market may have topped out by the average consumer that can cause homeowners or real estate investors to want to sell now, possibly even cut prices before things get even worse. This sort of anxiety mentality could be all the market needs to scare consumers from being too lax with their spending habits. Oil is the other story. It seems as if every day brings us a new high in oil prices and there is no sign of relief anytime soon. One of our favorite economists Nouriel Roubini postulated about whether the latest oil price shock could lead to a recession. He says that US consumers have so far treated the rise in oil prices as nothing but temporary and have continued to spend, dipping into their rising household wealth, borrowed more and more against it and reducing their savings rate to zero. Yet with this being a demand based shock rather than a supply based shock, there is no abnormal factor such as weather or geopolitically uncertainly that can later be corrected to make this a temporary phenomenon. This means that the 2 year rise in oil that we have seen thus far could be far from temporary. In fact, although Roubini and most of the world doesn’t believe that the latest oil shock will cause a recession, there is a near consensus that if prices stay at current levels or continue to rise, there could be a sharp contraction in growth. Roubini said, “this last installment of the oil shock may be the tipping factor that could trigger a consumption retrenchment, a bursting of the housing bubble and a significant economic slowdown.” If this really unfolds, it could spell disaster for the dollar in the second half of the year and this is not even considering the potentially negative implications of the end to the tightening cycle or Greenspan’s departure.


The Euro rebounded against the dollar today with a sharp break higher in the early European session with little follow through afterwards. The Eurozone current account balance came in much weaker than expected, dipping into negative territory, but the market wrote off the weaker headline number after they saw net capital flows increase by 400% in the month of June. The seasonally adjusted current account balance fell from a surplus of 1.9B to a deficit of 2.5B in June. With the deficit accounting for only 0.3% of GDP, it is of nominal consequence. Instead, capital inflows increased from EUR25.9 billion in May to EUR96.3 billion in June. If this isn’t evidence of possible global diversification in Euro-denominated assets, we do not know what is. Equity inflows increased from EUR22.4 billion in May to EUR61.5 billion in June. The bigger change though was in bond inflows, which increased from EUR7.2 billion to EUR47.5billion. As a percentage of GDP, this is a much more significant change and certainly a number of consequence.

British Pound

With no economic news on tap, traders pushed pound sterling higher after a brief pause on profit taking over the past four sessions. Momentum remains strong on the belief that the Bank of England will leave interest rates unchanged at 4.50%, bucking previous expectations of a wild decline. However, traders will, as a result, be scrutinizing economic data even more so in confirming this notion, lest any surprises turn the tide. With a slew of data this week, traders look to place special focus on two notables, the CBI industrial trends monthly survey and the gross domestic product for the second quarter. With economic growth slumping since the first quarter, economists and investors will look to see if consumer sentiment did indeed change on the most recent rate cuts, although effects may still be early. Most recently, housing price depreciation has actually bottomed as consumer prices have also increased, indicative of previous warnings that inflation remains a concern. However, with consumer consumption representing a large portion of the economy’s growth, pick-ups in domestic demand would ultimately be the nail in coffin, confirming a domestic turnaround and steady rates. Until then, traders will be left with some uncertainty until policy makers next convene in September as futures traders are siding with the overwhelming positive.

Japanese Yen

The Japanese yen cast aside the disappointing convenience store sales data and instead rose on subsequent financial and political factors. For one, Prime Minister Koizumi and his reform plan have garnered a good amount of positive public support according to a local survey. Even after the previous Japanese postal service reform debacle, Koizumi’s popularity has ballooned to 53%, with plenty of upside potential. Subsequently adding to this, the prime minister’s political party released its manifesto and stated its intent to fully back the passing of the reform bill, calming any further speculation of future lower house contention. As a result, not only can market participants bank on a political win in September, but further economic reform is sure to follow. With the political picture a bit more optimistic and grounded, investors additionally turned their focus to the rising equity markets. Continuing to close above the 12,000 psychological mark, the Nikkei 225 has remained above the figure, even rising to fresh four-year highs last night. Bolstered by positive future growth potential, foreign investors purchased the largest amount of Japanese equities in 17 months, $6.5 billion, last week. Ultimately, with both factors in favor of yen appreciation, a lot of pressure is being placed on future economic data, especially inflationary figures. Any rise in prices may ultimately warrant speculation on short-term rate considerations.


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