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Thursday December 22, 2005 - 21:37:41 GMT

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Forex: Dollar Weakens Ahead of Possible Yield Inversion

DailyFX Fundamentals 12-22-05

By Kathy Lien, Chief Strategist of

• Dollar Weakens Ahead of Possible Yield Inversion
• Inflation Still on the Minds of Dollar Traders
• Pound Extends Losses Following Weaker GDP and Wider Current Account

US Dollar

After three days of gains, the dollar has finally retraced against the Euro and Japanese Yen. However, dollar strength was not broad based as the greenback still managed to rally against currencies with a higher interest rate, such as the Australian Dollar, British Pound and Kiwi. This divergence indicates that for once in a long while, the dollar is not setting the tone for the market’s overall direction. Instead, weaker economic data from New Zealand and the British Pound sent those currencies lower while stronger reports from Japan and more hawkish rumors from Europe helped the currencies of those countries gain strength. In the US, data remained very mixed. Personal income increased an as expected 0.3 percent while spending matched that rise. Even though spending was slightly less than the market had anticipated, the country’s savings rate was negative for the sixth consecutive month. This is one of our biggest concerns because if the housing market does weaken as analysts have expected, consumers will not have much additional discretionary income to continue fueling our economic growth. Meanwhile jobless claims improved from 331k to 318k, which was not unusual, but certainly a nice surprise. The last US release of the day was leading indicators, which increased 0.5 percent in November after an upwardly revised 1.0 percent rise the previous month. With just one more trading day until the long weekend, flows have really begun to dry up. However, it may be too early to turn a blind eye to the markets since tomorrow delivers to us yet another dose of important economic data. We are expecting not only the durable goods orders report for the month of November, but also the University of Michigan consumer confidence report and new home sales. One interesting note is that the spread between 2 and 10 year yields is less than 4 bp. If the curve inverts, it is generally taken as a recessionary signal and the weaker outlook could explain why gold prices rallied $9 today.


The Euro recuperated some of its recent losses today as more rumors of an early interest rate hike circulated in the markets. Yesterday, Reuters carried an article citing an unnamed source that a rate hike could come in March. Today, a well known US based fund advisory also released predictions for an early rate hike. The ECB has been very quiet this week, perhaps because they are all in holiday mode, but today’s first glance at the inflation reports suggests that rate hikes may indeed still be on their minds while they sip their eggnogs. German import prices increased by a more than expected 5.5 percent while consumer prices in Saxony, Bavaria, North Rhine and Bradenburg all increased more than expected in the month of December. Other data was more mixed with Italian business confidence and retail sales increasing but Eurozone industrial new orders contracting. Tomorrow, we expect consumer price figures for Germany as a whole, but judging from today’s reports, tomorrow’s Eurozone data is expected to be more positive for the Euro.

British Pound

In contrast to the Euro, the British pound weakened for the fourth consecutive day. GDP growth for the third quarter was revised down to 0.4 percent from 0.5 percent while the current account deficit ballooned to GBP -10.2 billion from GBP –1.4 billion in the third quarter. Accounting for 3.4 percent of GDP, this is the highest level recorded in just under five years. Rising imports, an increase in foreign repatriation of profits due to the US Homeland Investment Act and insurance related payments tied to Hurricane Katrina has all contributed to the bulging deficit. JPMorgan UK Economist Malcom Barr made a great point when he said that “If UK domestic demand is as depressed as everyone believes, why are we importing so much.” His belief that underlying domestic demand may actually be stronger is supported by the 8 percent annualized rise in sales at John Lewis, a large UK department chain. Following the 7.1 percent rise last week, sales in the holiday season seem to be off to a good start.

Japanese Yen

The Japanese Yen strengthened against the dollar after three days of losses thanks to more encouraging economic data. The tertiary activity index increased by 1.2 percent, which is close to double market expectations. According to this latest round of data, the economic recovery in Japan appears to be continuing at a healthy pace. The trade surplus for the month of November printed at JPY 600 billion which was slightly less than the market expected, but still represents a strong increase in exports which rose 2.1 percent month over month to a new high. The weakness in the Japanese Yen has clearly been helping the export sector and also supporting the country’s economic recovery. The Ministry of Finance’s weekly flow data indicates that foreign investors continued to be net buyers of Japanese bonds and stocks while Japanese investors have increased their purchases of Australian, New Zealand and British bonds. Bank of Japan Governor Fukui reiterated his commitment to watching consumer prices and not the government’s recommended GDP deflator. He sees inflation increasing and the country’s moderate recovery gaining momentum in the year ahead.


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