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Tuesday July 13, 2004 - 21:20:34 GMT -

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Dollar Rallies as US Trade Deficit Narrows

DailyFX Forex Fundamentals 07-13-04

By Kathy Lien, Chief Currency Strategist of FXCM

· US Trade Deficit Narrows
· European Council Annuls Suspension of Sanctions On France & Germany Over Budget Deficit
· Bank of Japan Upgrades Assessment of Economy


After a week of strong gains, the Euro is finally experiencing a respectable retracement against the dollar following a better than expected US trade balance. During the London trading session, the European Council, the EU’s highest court, overturned a previous decision by finance ministers to overlook sanctions on France and Germany for breaching the stability and growth pact’s budget deficit limitations. The European Council founded the finance ministers’ decision to be illegal and said that it is “important to respect the stability pact.” However, France and Germany will still not face significant sanctions since EU governments can overrule the demands by the European Council to reduce deficits. This is the third consecutive year that Germany and France are expected to breach the deficit. Italy, the Netherlands, Greece and Portugal are expected to have deficits in excess of 3% this year - fiscal discipline has been a problem that many EU nations have been grappling with since the global downturn in 2001. Nonetheless, despite the budget deficits’ reappearance in the headlines, the Euro seems to shake off its significance and continues to allow its direction to be dictated by the dollar.


The better than expected US trade balance for the month of May has helped the dollar recoup some of its recent losses. The trade deficit narrowed from $48.09 billion to $45.95 billion, which is the first time in six months that the trade balance has improved. A surge in foreign demand for telecom equipment and civilian aircraft sent overall exports to record highs. During the month of May, the dollar index declined over 2%, which has helped to boost exports. Imports also increased to a record level, which is expected given that oil prices increased during the month of May and domestic demand generally rises as an economy recovers. Tomorrow, we are expecting retail sales, which is another key US economic release. Advance retail sales are expected to decline 0.8% after increasing 1.2% the previous month. Demand for autos are expected to be weak as suggested by the auto sales reports released last week. Ex-autos, retail sales are also expected to remain depressed since weekly Redbook retail sales reports have shown consecutive weeks of slower consumer consumption growth.


The mighty pound still remains mighty as today’s dollar positive news has only had a limited impact on the GBPUSD. Consumer prices increased 1.6% yoy in June from 1.5% yoy in May. Although on a monthly basis, CPI decreased, the overall pace of annualized inflation growth is the fastest since March 2003. Inflation is gradually increasing, and is expected to move above the bank’s 2% target in 2005. The recent surge in oil prices contributed to the increases in consumer prices. In response to rising inflation, the Bank of England has raised interest rates by 75bp since the beginning of the year. Yesterday’s house price inflation report from the Office of the Deputy Prime Minister (ODPM) reported continual increases in house price inflation. If consumer goods and house prices fail to abate, the market may have to tighten monetary policy once again in August. Tomorrow, we are expecting labor market data from the UK. The number of people filing for unemployment benefits has been declining since June 2003. The labor market is very healthy with the unemployment rate at the lowest level since 1975. Therefore the labor market data itself should receive limited attention. Instead, the market will once again focus on the inflation component of the report – average earnings. Annualized earnings growth is expected to accelerate by 4.5% as a tight labor market and lack of spare capacity pushes labor costs higher.


As expected, the Bank of Japan left monetary policy unchanged last night. They did however upgrade their assessment of economy for the first time in six months on signs of a “solid recovery” in the household sector. Annualized household demand has been in positive territory for the seventh consecutive month as of May. Prior to that, it was fluctuating between negative and positive growth (but mostly negative) since 1989. According to Takenaka, the job market is improving and household income levels have established a strong base line.” Industrial production accelerated 0.8% m/m and 4.6% y/y in the final release for the month of May, which was stronger than market expectations.

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