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FXCM - Dollar Rally Faces Hurdles at Present Level

DailyFX Fundamentals 07-17-06

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

• Dollar Rally Faces Hurdles at Present Level
• Is BoJ’s “Gradual” the Same as the Fed’s “Measured?”
• Sharp Drop in Gold Prices Sends Aussie Tumbling

US Dollar

Risk aversion around the world is sending traders piling into the long dollar trade. As geopolitical risks rise, so does the US dollar. The relative stability of the country and its high interest rates is making dollar denominated assets an attractive place to hide for many. However, the dollar’s rally could very well have run its course as we come up on major support in the EUR/USD and resistance in USD/JPY. It is time to refocus on fundamentals and the future of the US economy as we prepare for this week’s extremely busy US economic calendar. We have already seen the Empire State Manufacturing survey and industrial production report, which were conflicting and gave us little directional indication. The NY Fed survey reported surprisingly sluggish growth in the month of July which suggests more weakness in the months ahead. On the other hand, industrial production surged by 0.8 percent in the month of June and although the report is more backward looking, it marked the strongest quarter in seven years. Capacity utilization also hit a six year high which suggests that inflationary pressures are still prevalent. We look for confirmation of inflation pressures in tomorrow’s producer price and Wednesday’s consumer price reports. Strong numbers on both fronts will prompt traders to position for slightly more aggressive comments by Bernanke late Wednesday morning when he delivers his semiannual testimony on the economy and monetary policy. The market is still predicting another rate hike in August, especially in the context of higher energy prices which means that they will be relating incoming economic data with the need for tighter monetary policy. Aside from PPI, we are also expecting the net foreign purchases report (also known as TIC) for the month of May. After the weak $46.7 billion inflow reported in the month of April, we need to see inflow in excess of $60 billion for traders not to punish the dollar. One month does not make a trend, but two certainly raises that concern. The current forecast is already calling for a weak demand of $56 billion. With central banks talking of reserve diversification and the Dow plunging 600 points in the month of May, there is ample evidence that demand could be waning which would bring the US’ structural deficiencies back to the forefront.

Euro

The Euro has been moving to the tone of the US dollar as in line economic numbers and a clear stance by the European Central bank gives way to the uncertainty in the Federal Reserve and the world in general. Despite solid economic performance, the Euro has seen its longest stretch of weakness in a month. This suggests that once things calm down, we could see a nice rebound in the Euro if its fundamentals prevail. The high level of oil prices at a time when temperatures are also at record highs around the US poses a significant risk to US consumer spending. We already saw a surprising contraction in spending in the month of June and the risks are for repeated weakness in July. In fact, the yield curve has inverted even deeper indicating that traders fear the Fed’s aggressive stance could cripple the US economy. With the “dollar” component of the EUR/USD driving the pair’s price action, our primary focus will be on the US economy this week. Eurozone economic data continues to confirm the central bank’s need to raise interest rates in August. Consumer prices accelerated by 0.1 percent in the month of June, bringing the annualized pace of growth up to 2.5 percent, firmly above the ECB’s 2 percent target. Industrial production also remains strong, rising by a more than expected 1.6 percent in the month of May. This should be promising for tomorrow’s ZEW survey of economic sentiment as the combination of stronger economic data and the World Cup effect keep analysts optimistic on the health of the German economy.

British Pound

Like the Euro, the British pound fell victim to dollar strength. The sole scheduled release coming out of UK for the session was Rightmove's measure of housing prices leading into July. According to the release, the average price for homes on sale in the Kingdom rose 2.9 percent for the four weeks ending July 8th, while the annual gauge climbed to an impressive 10.6 percent pace. In itself, the jump in prices was a month away from a five-year high rate. However measuring it up in broad terms, it seems far from a foundation to a rebound in the housing market. Nationwide housing prices last month failed to reach conservative predictions of an increase, while the HBOS gauge for the same month actually declined 1.2 percent. A few explanations for the unexpected rise range from unusual activity in the south all the way to a lack of cheaper options in the summer months when developers move inventory. Whichever way it adds up, the fundamentals are not supporting a full return to a roaring housing market, which in some measures accounts for nearly 60 percent of consumers' total wealth. With unemployment running high, wages slowing and another cut to the overnight lending rate seemingly a ways off, there is little support for the Brits to jump into the expensive venture of new home ownership en masse. Some form of confirmation could be offered from the RICS price balance scheduled for tonight, but pound traders are really holding out for the CPI gauge scheduled for release at 8:30 GMT.

Japanese Yen

Last week, we saw broad based Japanese Yen weakness that was exacerbated by the neutral comments from the Bank of Japan after they raised interest rates by a quarter of a point. Today, the performance of the Yen was more mixed with the Japanese currency recuperating against the Euro, Swiss Franc and British pound, but extending its weakness against the US dollar. The future of the Japanese Yen is really dependent upon how much more you expect the Bank of Japan to raise interest rates. In a conversation with the Chief Currency Strategist of a leading Australian bank (interview to be posted on DailyFX in the next week), an interesting perspective was brought to the table. Although most interpreted the BoJ’s comments to mean no more rate hikes in the near future, it is possible that the BoJ’s usage of the word “gradual” is similar to the Fed’s use of the word “measured.” The Bank of Japan has seen the Fed’s success in taming the US dollar’s rise despite having raised interest rates by 425bp and they are mostly likely envious to do the same. As an export dependent economy, Japan has even more to lose if the Yen appreciates too quickly.

 

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