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Forex - Dollar Recovers After Strong Housing Data Offsets UAE Reserve Diversification

DailyFX Fundamentals 12-27-06

By Kathy Lien, Chief Strategist of

• Dollar Recovers After Strong Housing Data Offsets UAE Reserve Diversification
• Strong Housing Data Expected to Benefit the British Pound
• Yen Rises on Talk of BoJ Interest Rate Hike

US Dollar - With European, Asian and Canadian traders back at their desks for another shortened trading week, we have seen relatively exciting price action today. Two pieces of news dominated the financial market headlines and both resulted in offsetting reactions for the US dollar. The UAE announced in the European hours that they plan on selling US dollars and buying Euros, which led to a major sell-off in the US dollar. However earlier weakness was recovered after new home sales increased strongly in the month of November. Not only did sales rise by 3.6 percent in the month of November, but the median house price also increased by 5.8 percent. Upward revisions were seen to the October sales data as well, which is good news for the housing market. With two offsetting, yet important reports, the more lasting reaction for the US dollar will depend upon which theme persists. Existing home sales are due out tomorrow and a strong release would double the possibility of a recovery in the housing market next year. However, with mortgage applications dropping to a five month low last week and existing home sales being more of a lagging indicator, we remain skeptical of its potential strength. Looking ahead tomorrow is the busiest day for US data this week. In addition to existing home sales, we are also expecting consumer confidence, Chicago PMI and jobless claims. After the sharp drop in the Philadelphia Fed manufacturing survey last week, the Chicago PMI report could remain in contractionary territory. We may see some strength in consumer confidence however as the combination of low oil prices and a strong equity market fuel overall optimism.

Euro - As we have previously mentioned, the weakness that we have seen in the US dollar since Thanksgiving should resurrect plans of reserve diversification by central banks. The potential for lower US interest rates as well as the erosion of the US dollar’s value makes dollar denominated investments increasingly less attractive. The UAE central bank was the latest to say that they plan on converting 8 percent of their foreign exchange reserves from US dollars into Euros before the third quarter of next year. This would bring their euro holdings up to 10 percent from 2 percent. The Sultan was very specific in saying that they will accumulate "euros each time the market appears to dip." Although this is very important in cementing the Euro's status in the market, the UAE's $23 billion chest of reserves is nothing more than chump change when compared to China's $1 trillion worth of reserves. The only pieces of data released today were French housing starts and Italian retail confidence. Both releases deteriorated from the prior month, but neither were very market moving. We are expecting French unemployment, German Gfk Consumer Confidence and Eurozone M3 growth data tomorrow. All three reports are expected to be bullish for the Euro and if so, could help the currency extend its gains. Meanwhile, the Swiss Franc is weaker across the board after a disappointing UBS consumption report. This is just one more piece of evidence pointing to a slowdown in Swiss expansion, which the SNB has already noted with lowered inflation and growth forecasts for next year. Furthermore, the data does not bode well for the KOF Swiss leading indicator, one of the most important economic reports for the country, due out on Friday.

British Pound - The British pound is stronger today, although it has given back most of its earlier gains. Housing is and will be the market’s main focus over the next few days. Hometrack reported a 12.1 percent rise in house prices in 2006. The Nationwide Building Society will be publishing their own survey of house prices and the group is expected to report the tenth straight month of increasing home values. The combination of falling inventories and strong demand has been very positive for the market over the past year. Further strength in the Nationwide report will raise the chances for a rate hike by the central bank on January 10th. The rate hikes that we have seen thus far have done very little to slow the growth in the housing market and as such, the central bank may need to continue to drive rates higher.

Japanese Yen - The Japanese Yen is stronger across the board after the JiJi news agency reported the possibility of a 50bp rate hike in January by the Bank of Japan. Although we think this is extremely unlikely, on a day where we have reserve diversification in the headlines, the news has pushed some carry traders to unwind their positions. The interest rate markets are currently pricing in a 70 percent chance of a 25bp rate hike in January, but judging from the price action of the Japanese Yen, the FX markets may not necessarily be expecting the same. Economic data thus far has been mixed. Retail sales dropped more than expected in the month of November as wage growth remains limited. Housing starts have hit a 9 year high however. With both consumer price (reported last week) and retail sales growth disappointing, the BoJ has no other choice than to be extremely conservative with tightening monetary policy.

Commodity Currencies (CAD, AUD, NZD) – The commodity currencies are mostly stronger today against the US dollar despite the lack of any meaningful economic data. Bank of Canada Governor Dodge was relatively balanced about the outlook for the economy in the year ahead. Although he thinks that the service sector will see some strain from global competition, he believes that they will be able to handle the competition. He is slightly worried about the US economy, but less concerned about upside inflationary pressures. This suggests that rates will remain on hold in January. Meanwhile in New Zealand, local papers have been reporting on the potential damage that the strong New Zealand dollar is doing to the economy. Dominion Post said that many corporations have been surprised by the currency’s strength and have not properly hedged for it. As a result, earnings and profitability of those companies could falter in the months ahead.


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