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Forex - Dow Weakness Leads to Carry Unwinding

DailyFX Fundamentals 05-10-07

By Kathy Lien, Chief Strategist of

• ECB Remains Hawkish, but Euro Sells Off: What Gives?
• Dollar Strengthens on Better Jobs Data, but Watch Out for Weak Retail Sales and PPI
• Dow Weakness Leads to Carry Unwinding

Dollar Strengthens on Better Jobs Data, but Watch Out for Weak Retail Sales and PPI

The US dollar is up strongly today against the Euro and British pound in a classic buy the rumor, sell the news type of price action. After the Bank of England and European Central Bank did exactly what the market expected with no additional surprises, the flood gates were opened and in charged dollar bulls. US economic data was mixed, which means that good data can only take partial credit for contributing to the move. Jobless claims were exceptionally strong, falling another 9k to 297k last week. We have not seen claims dip below 300k since January and non-farm payrolls that month was a robust 162k. With two back to back weeks of strength, there is a decent chance that we may see strong employment next month. Last week’s number already gave the market confidence to downplay the softer non-farm payrolls release. Unfortunately, this was the only piece of dollar positive news released today in a sea of negative data. The trade deficit increased to a 6 month high of -$63.9 billion while the annualized pace of import prices slowed from 2.8 to 1.9 percent. The worst news of the day was the ICSC chain store sales report. According to the data, not only did chain store decline for the first time since March 2003, but the drop was also the biggest on record. Going into tomorrow’s retail sales and PPI numbers, today’s import prices and chain store sales reports suggest weaker outcomes. Record gas prices are preventing many consumers from making big ticket purchases. For more on the impact of gasoline on retail sales and PPI, see our Gas Report. If consumer spending prints negative, except a reversal in the dollar that is as strong as today’s rally. The market is currently riding on the coat tails of yesterday’s hawkish FOMC statement and today’ jobless claims number. If consumer spending slows, the Fed may have to reconsider their stance on monetary policy.

ECB Remains Hawkish, but Euro Sells Off: What Gives?

The European Central Bank left interest rates unchanged at 3.75 percent and indicated that “strong vigilance” was needed. This is their way of telling the market to expect a rate hike in June. The prospect of 4.00 percent rates last month should have been positive for the Euro, yet the currency sold off significantly against the dollar, befuddling traders in the process. Unfortunately, doing exactly what the market expected was probably the worst possible outcome. Four percent money has long been priced into the market. What traders were really looking for was a hint of further rate hikes in the months to come. When faced with this question, Trichet said point blank that he won’t comment on what they will do after June. The central bank clearly wants to wait for another month of economic data before deciding whether to bring interest rates up to 4.25 percent. At this point, Trichet’s tone is clearly leaning towards more hikes, but at the same time he may not choose to raise rates if there is more evidence that the prior strength of the Euro is hurting the economy.

Bank of England Raises Rates, but Keeps Mum on Future Hikes in Fear of Driving GBPUSD Above 2.0

Even though the Bank of England raised rates to 5.50 percent, the British pound tanked. Unfortunately the tone of the central bank was less hawkish than most traders were anticipating. With the futures curve pricing in 6.00 percent interest rates by the end of the year, traders were really looking for comments alluding to another rate hike in June. Not only did King fail to comment on future policy actions however, he also downplayed the level of consumer prices by saying that he expects consumer price inflation to fall back to 2 percent this year. With the GBP/USD trading not far from 2.00 at the beginning of the London trading session, the central bank probably did not want to do anything that would drive further strength in the currency. Raising interest rates at a time when the pound is so strong could dampen economic growth going forward. According to this morning’s report, the March trade deficit hit the highest level in 10 months and we are sure that the strength of the currency is to blame. Meanwhile industrial production also fell short of expectations. Prime Minister Tony Blair announced today that he will be stepping down on June 27. For more on the impact of this, read our outlook on Blair’s Resignation.

Dow Weakness Leads to Carry Unwinding

The Japanese Yen reversed all of its earlier losses as the selling in the Dow began to exacerbate. We have long said that the correlation between carry trades and the Dow is strong and this time around noon, we watched the Dow hit -100 minutes before USD/JPY broke down. The turnaround in the Dow today was sharp enough that we could see a similar move lower in the Asian markets tonight. As the funding currency for a lot of speculative stock investments globally, the yen could reverse as carry trades continue to be unwound. Meanwhile, the Japanese economy continues to remain weak as the Eco Watchers survey dipped into contractionary territory in April. Despite the weakness of the Yen and the increase in corporate profitability, the man on the street is not feeling the same optimism as investors and corporations.

Australian Dollar Benefits from Hot Unemployment, CAD Labor Market Data up Next

The Australian dollar managed to hold steady today thanks to last night’s exceptionally strong employment numbers. Not only did employment rise by 49.6k, but the unemployment rate actually fell to 4.4 percent, the lowest level since 1974. The New Zealand dollar on the other hand did not see the same strength as unemployment increased from 3.7 to 3.8 percent. With interest rates at 7.75 percent, businesses are really feeling the pain, which explains why the ANZ business PMI index slipped from 56.8 to 54.2. Canadian unemployment is due for release tomorrow. The market is looking for softer employment growth. After 3 months of strong additions to the labor market, it will be logical to see a retracement in hiring. However, the employment component of the IVEY PMI increased in the month of April which suggests that any slowdown in hiring could be limited.


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