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Friday April 21, 2006 - 21:36:15 GMT

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Forex: Things Get Worse for the Dollar as Reserve Diversification Resurfaces

DailyFX Fundamentals 04-21-06

By Kathy Lien, Chief Strategist of

• Things Get Worse for the Dollar as Reserve Diversification Resurfaces
• Switzerland Increases Yen Reserves
• Commodity Currencies Continue to Rise as Oil Climbs to New Record High

US Dollar

In yesterday’s Daily Fundamentals, we talked about how the US dollar rallied while oil prices sold off for no reason other than exhaustion. We indicated that the themes have not changed which means that any further extension moves would probably have been limited. That was exactly what we saw today as the dollar resumed its slide while oil prices hit a new all time high. Sparked by the release of the FOMC minutes from the March 28th meeting, fundamentals turned sharply bearish for the dollar this week. On a day devoid of any US economic data, we were surprised to see a fresh wave of selling on news from Sweden. Bringing reserve diversification which is one of the biggest deterrents to long term gains in the dollar back to the forefront was the announcement by Sweden’s central bank that they have cut their dollar reserves by 17 percent and increased their euro reserves by 13 percent. Russia took this opportunity to add their two cents by saying that the dollar was not the “absolute” reserve currency and the country’s trade and current account deficits could affect’s it attractiveness in the future. Data from Switzerland also indicates that the central bank has reduced the share of dollars in its reserves and instead has increased its share of yen reserves. This comes on the heels of comments by Iceland on Wednesday about their possibility of abandoning the volatile Krona in favor of the more stable Euro. This fresh wave of reserve diversification talk has enough punch to take the Euro back to its previous highs, but before it does so we have few US events that are worth watching. No economic data is due for release on Monday, but we will be receiving consumer confidence on Tuesday. Given the climb in oil prices and the slowdown in the housing market, confidence is more likely to deteriorate than improve this month. On Wednesday, we are expecting Durable Goods and New Home Sales. On Thursday, Federal Reserve Chairman Ben Bernanke will be testifying on the economy, which will be an event not to be missed. At many other recent speaking engagements, Bernanke has refrained from mentioning the economy, so each time he is actually scheduled to talk about it, we will be paying particular attention especially since the market will be looking for his validation of the more dovish tone reflected in the FOMC minutes. Finally on Friday we are expecting the advance release of first quarter GDP along with the University of Michigan Confidence report and the Chicago Purchasing Managers index.


The Euro continued to climb higher driven by the reserve diversification factors mentioned in the US dollar section of this report. Economic data out the region was also mixed, which added little to today’s move. French consumer spending fell less than expected in the month of March, but there was also a downward revision to the February number. The country’s recovery continues to be modest at best, but the improvement in the labor market is helping to keep consumption steady. The Italian trade balance narrowed in the month March, but by far less than the market had been anticipating. Given the rally in the Euro and higher oil prices, exports were predicted to suffer, but they didn’t thanks to the rise in industrial orders. Meanwhile February retail sales came in slightly weaker than expected, rising by a mere 0.1 percent. In the week ahead, there are a lot of important pieces of Eurozone economic data due for release including the region’s trade balance, German retail sales, German industrial production, the IFO report and Eurozone Industrial production. There is also little rumor circulating on the possibility of a significant decline in April German unemployment, which would reverse the sharp rise we saw in March. The G7 meeting is going on at the moment and IMF / World Bank meetings are scheduled for this weekend. Therefore we would not be surprised to see more comments from policy officials around the world similar to the ones made by Russia this morning. In all likelihood, any meaningful comments will probably not be dollar positive.

British Pound

After yesterday’s dip, the British pound regained strength against the US dollar and remained basically unchanged against the Euro today. The weekly department store sales report from John Lewis showed another strong week of consumer spending which is certainly encouraging going into next week’s retail sales report. Aside from that, we are also expecting GDP numbers for the first quarter, consumer lending figures and the Nationwide house price report. After the inflation figures released yesterday, the market is worried that the Bank of England may be leaning closer to lowering rates now than keeping them on hold. This makes the rest of the releases due this week even more important to either confirm or deny that. Judging from the market’s forecasts, weakness is expected more than strength.

Japanese Yen

The Japanese Yen rallied against all of the major currency pairs today except for the Australian dollar. Even though Sweden’s Riksbank announced that they reduced their yen reserves from 8 percent to zero, reports that Switzerland increased its Yen reserves helped to keep the currency lifted. Today’s rally appears to be driven more by end of the week profit taking in the crosses than fundamentals. China stood firm on their currency policy and did not announce any changes during President Hu’s visit to the US. With the G7 meeting this weekend, there is the possibility that harsher words may be used towards China in the Communique, and if it does, even though it will probably have little influence of China’s decision, the greater emphasis on the subject may weigh over USD/JPY. Oil prices hit a new record high above $75 a barrel which over the long term should also have negative impacts on the Japanese economy. Meanwhile the Japanese economic calendar is very light next week, but important reports from Australia and New Zealand should still make Asian session trading interesting.


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