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Tuesday October 3, 2006 - 21:18:28 GMT

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FXCM - Drop in Oil Prices and Rally in Dow Sends Dollar Higher

DailyFX Fundamentals 10-03-06

By Kathy Lien, Chief Strategist of

• Drop in Oil Prices and Rally in Dow Sends Dollar Higher
• ECB – The Only Central Bank Left Increasing Interest Rates
• Japanese Finance Minister Declares End to Deflation

US Dollar - Milestones were reached in the financial markets today, but unfortunately, none of them were currency related, at least not yet. The time will come for the currency market, but today we saw a new all-time high reached in the Dow Jones Industrial Average and watched oil prices drop to the lowest level since February 2006. Both of these movements are good for the US dollar which explains why it rallied on an otherwise quiet trading day. The weaker price of oil will continue to reduce global inflationary pressure, pushing more central banks to drop their hawkish bias and move to the sidelines while also helping to encourage more consumer spending. For the Federal Reserve specifically, it gives them extra breathing room to lower interest rates at the first sign of significant weakness in the US economy. Previously they may not have been able to act as quickly in fear of causing inflation problems in the future, but with that concern falling as oil prices fall, they can be more proactive rather than just reactive. We also want to point out that there are rumors circulating in the markets that another hedge fund could be in trouble. It is unlikely that Amaranth Advisors was the only fund to be leveraged significantly into the long commodity trade. The rally at the time was too attractive for most investors to ignore. If this is true, it raises the risk of a liquidity problem for the financial sector as a whole since many banks would have offered credit lines for the fund. In our special report on the banking sector a week ago, we had said that if these defaults begin to become more widespread, the Federal Reserve may have to step in to stimulate the economy and increase liquidity, just like they did in 1998. Meanwhile tomorrow there are a few events that we will be watching closely which are service sector ISM, the ADP Employment Change, Factory Orders and the three speeches by Fed officials including one by Bernanke. In terms of ADP and ISM, we will continue to look for any clues or leading indications of how Friday’s payrolls report could be released. If the employment component of the service ISM and the ADP fall significantly, we would have confirmation of our belief that payrolls were weak in the month of August. Bernanke, Kohn, and Geithner are all voting members of the FOMC and each of their topics has the potential to touch on current economic developments as well as contain clues on their monetary policy stances. We are looking for a breakout in the dollar over the next two weeks and any of these speeches or the non-farm payrolls report has the potential to trigger that.

Euro - Incoming European economic data continues to suggest that ECB President Trichet may tone down his hawkish guidance at their monetary policy meeting on Thursday. Both growth and inflation is decelerating as the unemployment rate ticked higher from 7.8 percent to 7.9 percent while producer prices grew by a much weaker than expected 0.1 percent in the month of August. Knowing all too well that the current strength of the Euro and the prospects for further strength hinders economic growth, Trichet may put a break on rate hikes sooner rather than later. There are still many analysts predicting two more rate hikes this year, but the odds for the central bank to shy on the side of caution and opt for one instead of two rate hikes is certainly growing. The ECB is the only major central bank that is still increasing interest rates at the moment which explains why the Euro is holding up so well. We may see more from Australia and Japan, but at least for this month, both are expected to keep their own interest rates on hold. EUR/JPY is trading at a very critical level and ECB comments will be the deciding factor of whether we see a fresh high in the currency pair or a double top. In the US dollar section, we had mentioned that we expect a breakout in the EUR/USD over the next two weeks. This is based upon a great observation made by our technical analyst, Jamie Saettele in his Daily Technical report this morning. He pointed out that the Bollinger Bands is the tightest ever for the EUR/USD since its inception and if we look back 10 years with synthetic prices, there are only two instances when volatility was this low – December 1996 and August 1998. Both instances led to breakouts within 2 weeks and moves of over 1,000 pips in less than 2 months. This is a unique development that we choose not to ignore.

British Pound - Despite weaker UK economic data, the British pound extended yesterday’s gains against the Euro and US dollar. Both the construction sector PMI report for September and mortgage equity withdrawal in the second quarter fell short of expectations, but the details were less discouraging and still point to stabilization in the housing market. More importantly, another wave of merger and acquisition news is keeping the pound in demand, especially after the UK reported a rise in overall corporate profitability in the second quarter. There is also talk that the Bank of England could resurrect its interest rate hikes later this year. Money markets are still forecasting another quarter point rate hike by the year’s end but we think this is unlikely after the recent error made by the ONS in forecasting inflation.

Japanese Yen - News that North Korea will soon be testing another nuclear weapon has sent the Japanese Yen tumbling against the US dollar, Euro and British pound. If it were not for the rising geopolitical tensions, what we would most likely see today is more yen strength than weakness. Comments from Japanese officials overnight were mostly positive with new Finance Minister Omi declaring an official end to deflation while Economics Minister Ota talked up the health of the overall economy. These comments suggest that the Japanese government under Abe may be far more aligned with the Fukui’s stance on interest rates and economic growth than the government under Koizumi. Ratings agency Moody’s has already expressed their satisfaction with the new Prime Minister. They expect Japan’s credit rating to improve under the policies outlined by Abe. It appears that the market seems to have big hopes for Japan’s new Prime Minster.


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