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Thursday June 8, 2006 - 21:04:24 GMT

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Forex: EUR/USD - A Bottom Here or 100 Points Lower Will Depend on Trade Balance

DailyFX Fundamentals 06-08-06

By Kathy Lien, Chief Strategist of

- EUR/USD - A Bottom Here or 100 Points Lower Will Depend on Trade Balance
- Lack of the Word Vigilance from the ECB Sends EUR/USD Tumbling
- Weaker Data from the UK Continues to Weigh on the British Pound

US Dollar

The US dollar staged an extremely strong rally today, rising 1.3 percent against the Euro to the highest level in a month. The catalyst for the rally came from the left field as news that Al-Qaeda’s leader in Iraq, al-Zarqawi was killed in a raid, sending oil and gold prices tumbling. Though the significance of his death remains questionable since the real tensions these days is with Iran and not Iraq, after a week of consolidation and then some bullish comments from Bernanke, the market was looking for any reason to rally the dollar even further. The same goes for commodity prices, they have already been quietly selling off as Iran shows willingness to consider cooperating with the rest of the world. Prices were just sitting at a tipping point allowing al-Zarqawi’s death to easily tip the dollar and the other commodities over. After such a sharp move, further losses will probably be limited. However whether we stop here at 1.2650 or bottom out at 1.2550 will all depend upon tomorrow’s trade balance report. After contracting in March, the deficit is expected to rise once again in April. If you recall, last month we had said that the trade deficit contracted because the rise in oil prices happened in April and not in March which meant that the balance for the following month would be much worse. Now that we are expecting data for the following month, it is time to account for that rise. In fact with oil prices having hit a record high in April, a forecast for the trade deficit to widen from -$62B to -$65B could actually be a conservative estimate. Meanwhile Fed officials continue to be hawkish with Kohn, who is a voting member of the FOMC acknowledging that there is a slowdown in the economy, but warning that the Fed needs to be “quite attentive to inflation” risks. These are the same words we have heard from the endless list of central bankers over the past few days. Both Volcker and Greenspan were great inflation fighters and perhaps Bernanke is trying to prove that he can be as well.


Over the past four days, the Euro has fallen 300 points, with today’s move being the largest. The US dollar was already strong going into the ECB meeting on the back of al-Zarqawi’s death, but the lack of clearly hawkish comments from the European central bank gave dollar bulls an even better reason to take the EUR/USD lower. As expected, the ECB raised interest rates by 25 basis points to 2.75 percent. However, even though ECB President Trichet told the markets that interest rates were still accommodative suggesting that more rate hikes are ahead, the lack of the word vigilant in any of his comments was slightly less hawkish and more neutral than the market was anticipating. The market never likes surprises and the need to adjust to a more hawkish Fed and a less hawkish ECB has caused a great deal of volatility. We expect this volatility to continue as the market eventually needs to readjust itself when the Fed announces that they are done with rate hikes. This volatility is not limited to the currency market as the CBOE’s Market Volatility Index hits a three year high. For those who may have been calling for a half point hike, the ECB went with the more conservative option because of the value of the Euro, the lofty level of oil prices and the deep slide in the financial markets. They feared that a half point hike would send the equity markets tumbling further. In addition, they notched lower their growth forecasts for next year from 2.0 percent to 1.8 percent, citing the impact of oil prices. Even though we expect a great deal of Eurozone economic data tomorrow, the lack of clear hawkishness in the ECB’s comments today will downplay any upside surprises in economic data, letting the market focus exclusively on the US trade balance report.

British Pound

Weak economic data, the lack of an interest rate hike by the Bank of England and broad dollar bullishness pushed the British pound lower today. Although the Bank of England’s decision to leave rates unchanged for the tenth month in a row was completely within expectations, the sharp drop in industrial production and weaker housing data were not. In the month of April, manufacturing activity slipped by 0.6 percent while manufacturing production fell by 0.2 percent. Both were well below expectations and pose a big risk to future growth for the sector. Halifax, the UK’s largest mortgage lender also reported slower house price growth, giving the Bank of England good reason to continue to leave interest rates on hold. Given the recent trend of economic data, the central bank will probably remain on hold until the fourth quarter and even then, a rate change is not guaranteed.

Japanese Yen

The Japanese Yen is weaker against the US dollar once again, but stronger against the other major currencies. There was little economic data released overnight, but the slide in the equity markets and dovish comments from Japanese government officials gave Yen traders something to key off of. Cabinet Secretary Abe said that deflation is still a problem in Japan which is an important focus for the central bank, who has pledged to leave rates at zero until deflation is eradicated. Comments from BoJ Iwata confirm that the central bank is in no rush. He said that there is no predetermined path to raise interest rates and that the move will come in due time in response to economic data and prices. Overall, the BoJ will be patient and in an environment where the US Federal Reserve is not, the dynamic will be extremely beneficial for USD/JPY . Meanwhile further south, the Reserve Bank of New Zealand left interest rates unchanged at 7.25 percent yesterday. This decision was also in line with expectations, but what was surprising was the slight hawkishness from the central bank. Having talked down the currency on multiple occasions, the market was expecting more neutral or dovish comments. Instead, the RBNZ said that they do not plan on cutting interest rates this year because of inflation fears.


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