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Tuesday January 3, 2006 - 21:28:23 GMT
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Forex: Dollar Sees Largest One Day Slide in 4 Years

DailyFX Fundamentals 01-03-06

By Kathy Lien, Chief Strategist of www.dailyfx.com

• Dollar Sees Largest One Day Slide in 4 Years
• Euro Soars on Strong Data
• Dollar Weakness Masks Pound’s True Colors

US Dollar

On the first day of official trading in 2006, the dollar has weakened significantly against the majors, with the dollar index seeing its largest one day decline since September 11, 2001. Given that a new year long uptrend began on the first trading day of last year, we wonder if today’s breakout move would be indicative of a new trend that may be emerging this year. So far, the cards are stacking higher against the dollar, but with a busy week ahead and Greenspan bowing out at the end of this month, it remains to be seen if the current downside momentum can be sustained. Today, the combination of weaker economic data, dovish FOMC minutes and higher oil prices all weighed on the greenback. The national ISM manufacturing activity index slipped to 54.2 from 58.1. The market was only expecting a moderate retracement to 57.4, but broad based weakness dragged the overall index lower, raising concerns about whether the sector is growing fast enough to spur job growth. Construction spending hit a new record high in the month of November, but with only a 0.2 percent rise, the growth was far below the market’s 0.7 percent forecast and slower than the previous month’s 0.8 percent growth. Oil prices are up close to $2 following the Russian – Ukraine gas dispute that disrupted flow to most of Western Europe. Although gas supplies to Europe have since returned to normal, this is a far more deep seeded conflict that could resurface since Russia is adamant about increasing prices to the Ukraine while the Ukraine acts as Russia’s doorway to Europe. 90 percent of Russia’s gas exports pass through Ukraine, supplying 40 percent of the EU’s oil. At present, it seems that Russia is only siphoning out enough oil to meet their customers’ needs, leaving no spare supply for the Ukraine. For the time being, the Ukraine has enough supplies to last for a few weeks which will keep oil speculators at bay and this issue on the back burner, but if they exhaust that supply and resort to extracting oil from the pipeline before negotiations are completed, Russia would accuse them of stealing the oil and we could see another shock to oil markets once again. In the meantime, the bigger focus continues to be the Fed. The FOMC minutes released today reflected the varying views on the degree of future rate hikes. Additional increases “probably would not be large” and “members thought that the policy outlook was becoming considerably less certain.” With the yield curve inverting last week and now near flat, the Jan 31 rate hike could be the last one before we see a pause. If so, then today’s move could very well be indicative of a new trend this year.

Euro

The Euro is starting 2006 with a bang. Not only is it benefiting from broad dollar weakness, but it is also basking in improvements to its own data. Manufacturing activity in the Eurozone as measured by the PMI survey increased from 52.8 to 53.6 in the month of December with the first factory job growth in 4 years. The Italian retail confidence index increased to 105 from 104 while French GDP was confirmed at 0.7 percent for the third quarter. One of the biggest surprises today however was the sharp drop in German unemployment last month. Expected to only dip by 8k, the index fell for the third consecutive month thanks to mild weather. Dropping by 110k, this is the biggest one month improvement since the German reunification in October 1990. Overall, we see a stronger reason for the European Central Bank to remain hawkish in the first quarter of 2006. According to their latest press conference and recent comments, the ECB still feels that monetary policy is “accommodative,” but knowing that their recovery has been engineered by the weakness of their currency, they remain cautious about prematurely following up their December move with another quarter point hike.

British Pound

The weakness in the US dollar has driven the GBP/USD currency pair higher by 270 pips today. The breakout move mirrors that of the EUR/USD but the relatively smaller rise and the complete divergence in pound performance against other currencies indicates that the dollar’s weakness is masking the market’s real perception about the health of the British pound. The UK manufacturing sector index for the month of December increased marginally from 51.0 to 51.1 last month. The rather anemic performance best sums up the country’s overall performance last year, which is growth albeit but weak unimpressive below trend growth. In fact, according to a survey by the FT, most economists believe that the Treasury and Bank of England’s forecast for economic growth this year is too optimistic. There are also fears that colder weather may have dampened sales during the usually strong Christmas shopping season. As we start the New Year, the Bank of England still maintains their neutral policy, but will continue to be watching for signs about whether another rate cut may be needed.

Japanese Yen

With the Japanese markets closed overnight, US and European traders had their way with USDJPY today. Typically Japanese traders will inject a bit more two way action when they join markets, but with trading only open for half of a session tonight, there is little hope that USDJPY could recuperate its losses. According to a poll by Nikkei Net, most traders are expecting USDJPY to trade lower in the year ahead. The primary reason is the market’s expectation that USDJPY will be gradually becoming a less attractive carry trade investment. With the US Fed beginning to slow rate hikes and the Japanese government debating about when to drop its quantitative easing policy, the future attractiveness of USDJPY is beginning to fade.

For more research, please visit www.dailyfx.com

Also, check out Kathy Lien's newest book "Day Trading the Currency Market" on Amazon today!

 

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