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Forex - Dollar Rallies as All Signs Point to a Soft Landing

DailyFX Fundamentals 10-13-06

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

• Dollar Rallies as All Signs Point to a Soft Landing
• Improving Data Helps to Keep Pound Losses Limited
• Bank of Japan Fukui Signals that a Year End Rate Hike May Still be Possible

US Dollar
The influx of surprisingly strong US economic data has made it difficult for the US dollar not to rally. Recession forecasters as well as hard landing advocates have probably reverted back into their shells as US consumer confidence hit a 1 year high and retail sales excluding gasoline prices jumped 0.6 percent to the second highest reading in 6 months. Even though the headline retail sales number was the worst that we have seen since May 2002, the decrease was primarily due to a hefty 9.3 percent drop in gasoline station sales, which can be perceived as a positive for the US consumer who has had to deal with high prices at the pump for more than six months. This has left room for additional spending on sporting goods, general merchandise and clothing, just like the Redbook and same store sales reports have been signaling. If oil prices continue to remain low, the strong confidence of consumers, as measured by the University of Michigan survey, could lead to more spending in the months to come. For doomsday forecasters, a soft landing may be all that they will see as the latest data indicates a very lively consumer base, pushing out any possibility of an interest rate cut by the Federal Reserve early next year. The dollar’s rally reflects the changing sentiment of the market and it will be up to the data due in the week ahead to determine whether the US dollar has what it takes to break 1.25 against the Euro and 120 against the Japanese Yen. The calendar is very heavy with producer and consumer price reports due for release along with the numbers for net foreign purchases of US securities, industrial production, the Philadelphia Fed manufacturing survey, housing market indices and a number of speeches by Federal Reserve officials including Chairman Bernanke on Monday.

Euro
Although the Euro bounced yesterday, 1.25 was indeed a level that was too tempting for traders not to take a stab at. Rightfully so, the psychologically important level has proven to be stiff support as the EUR/USD closed the week at 1.2510. Unfortunately, it is unclear whether the support will hold as today’s US data supports the recent dollar rally. However, with manufacturing and inflation indicators the first numbers to be released next week, the risk is still for weaker rather than stronger reports. If this is the case, we could see some consolidation and maybe even more of a bounce. Inflation numbers have been falling globally and we doubt that the US would escape the impact as well, especially after seeing the sharp drop in gasoline prices in the retail sales report today. This morning, France reported a 0.2 percent slide in consumer prices in the month of September, which was worse than the flat reading that the market was expecting. This brought the annualized rate down to 1.2 percent and the harmonized EU rate down to 1.5 percent, far below the ECB’s 2 percent inflation target. However, the central bank’s message is clear and they plan on continuing to raise interest rates in the months to come. This should keep losses in the EUR/USD limited, especially since there are multiple support levels not far from here. In the week ahead, we are expecting more inflation indicators from the Eurozone as well as the trade balance report and the German ZEW survey.

British Pound
Like the Euro, the GBP/USD has fallen victim to broad dollar strength. However, the British pound was able to hold on far better than the Euro thanks to a jump in the Financial Times house price index and a strong uptick in consumer spending at the John Lewis Department store, one of the UK’s top ten retail businesses (this index is released on a weekly basis). Economic data is beginning to improve and we suspect that this may be one of the reasons why Bank of England monetary policy committee members have been more hawkish as of late. In the week ahead, the UK will be releasing inflation, employment and retail sales data along with the first release of third quarter GDP. No surprises are expected there as the labor market remains tight and spending remains consistent. The Bank of England will also be releasing the minutes from their latest monetary policy meeting earlier this month. Given the recent comments from BoE officials, the minutes could be more hawkish.

Japanese Yen
The Japanese Yen wants to turn and it has against the Euro, Canadian dollar and Swiss Franc, but it struggling to do so against the US dollar. Yen fundamentals continue to favor a reversal in the currency’s latest downtrend, but the resurgence of interest in carry trades has capped gains. Last night, Bank of Japan governor Fukui surprised by the markets when he said that a rate hike cannot be ruled out this year. Although we doubt one is likely since Prime Minister Abe was adamant in ensuring that the market realized that deflation was not beaten, it does reintroduce the possibility. The domestic corporate goods price index increased more than expected in the month of September, suggesting that inflation is still prevalent. Also, the longer the Japanese Yen remains weak, the more beneficial it is for economic growth. At some point, that growth will have to be reflected in a strengthening yen. Traders are extremely short USD/JPY at this point which is no surprise since 120 is a very important resistance level. However, we suspect that there are a ton of stops above that price, which means that if the currency does break through it, the additional rise could be sharp and fast – and it would be unwise to rule out the possibility of a break. Japan has a light economic calendar next week, with only the tertiary activity index and leading indicators due for release. We are also expecting the minutes from the Bank of Japan meeting last month as well as a few speeches from Fukui in the week ahead.

 

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