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Forex - Commodity Currencies Rally as Carry Trades Resume Their Rise

DailyFX Fundamentals 05-11-07

By Kathy Lien, Chief Strategist of

• Dollar Rises Against Yen, But Slips against Euro: Why is there such Divergent Price Action?
• Evidence that Euro Strength is Alleviating Inflation Pressures Could be Seen Next Week
• Commodity Currencies Rally as Carry Trades Resume Their Rise

Dollar Rises Against Yen, But Slips against Euro: Why is there such Divergent Price Action?

When talking about US dollar strength or weakness, traders these days need to distinguish between whether they are talking about the dollar’s value against the Euro, British Pound, or Japanese Yen. For most of the week, we have seen the dollar fall in value against the Yen while strengthening against the Euro and British pound. Today, the price reaction in the currency market was the exact opposite with USD/JPY, EUR/USD and GBP/USD all rising. Many people may be wondering why there is such a big divergence in the US dollar’s performance. In order to understand the possible reasoning behind the movements, traders need to realize that the purest reflection of the market’s sentiment towards the US dollar is seen through the currency’s value against the Euro. We have long called the EUR/USD the anti-dollar because it moves most often on underlying US fundamentals. Today is a perfect example as softer retail sales, producer prices and business inventories sent the dollar tumbling against every other currency except for the Japanese Yen. USD/JPY on the other hand, is a different animal. With the Japanese having no plans to raise interest rates and the carry advantage so skewed in favor of the US dollar, the main driver of the movement in USD/JPY has been carry. If you look very closely, you will actually see that it is buying of the yen crosses that is leading USD/JPY higher. On a percentage basis, the movements in EUR/JPY, AUD/JPY and GBP/JPY have been far greater than the movements of USD/JPY. The correlation between the Dow and carry trades is something that is not just unique to USD/JPY and in fact relates to the entire basket of carry trades. Today’s inflation, business inventories and consumer spending data tells us that the US economy is still in a precarious position. Both retail sales and core consumer prices stalled in the month of April. Although there are some external factors that may distort these results such as an early Easter, the sheer downward surprise does suggests that consumers are feeling the pain of high gasoline prices. In the week ahead, inflation will be a big focus for the currency market. Even though gasoline prices did not hit PPI significantly, we do expect to see a greater impact on consumer prices or CPI. In addition to the inflation data, we are also expecting reports from the manufacturing sector. The weak dollar should continue to help the sector recover. Overall, based upon these expectations, we could see the dollar resume its strength next week.

Evidence that Euro Strength is Alleviating Inflation Pressures Could be Seen Next Week

The Euro has finally rebounded after three straight days of weakness on the back of weaker US economic data. There was no European data released last night. Yesterday, the ECB left interest rates unchanged and President Trichet failed to comment on further rate hikes aside from the one that is priced in for June. Interestingly enough, we are beginning to hear less hawkish commentary from Eurozone officials. ECB Constancio said this morning that he expects inflation to be at 2 percent or less this year. This comment comes at an opportune time as the market turns its focus on inflation next week. The Eurozone, France and Germany are all releasing consumer prices. We are expecting softer inflation growth because the rise in gasoline in the US is mostly a domestic issue. Also, the prior strength in the Euro further reduces inflation pressures. Meanwhile in addition to CPI, we are also anticipating GDP and Eurozone industrial production. At this point, it will be difficult for the EUR/USD to strengthen beyond its all time high of 1.3680.

British Pound Rebounds despite Mixed Economic Data

Like the Euro, the British pound has also strengthened today against the US dollar and Japanese Yen. There were only a few secondary reports released including wage growth, department store sales and the NIESR GDP estimate. According to those reports, wage growth held steady, consumer spending growth slowed and GDP is estimated to be unchanged from the pace of growth seen in the first quarter. All three of these indicators are beginning to show the difficulties that the UK economy may be facing with the pressure of a strong currency and higher interest rates. We already saw the trade balance for the month of March hit a 10 month high. Next week, we expect similar weakness in unemployment, leading indicators and possibly even retail sales. As for PPI and CPI, the strength of the pound should alleviate inflation pressures. The Bank of England will also be releasing their quarterly inflation report, which tends to be a market mover.

Yen Crosses Rebound Strongly Thanks to Dow Rally

The strong rebound in the Dow today has led to a strong rebound in the Yen crosses. It appears that the movement in the US stock market is the only driver of trading for the Japanese currency these days. There was no data released last night, although China did report a larger than expected trade surplus (our China Weekly has more details). Meanwhile the Japanese data calendar next week contains a number of important releases including CGPI, current account, industrial production, GDP, tertiary activity index and the Bank of Japan rate decision. The central bank is not expected to change interest rates, but the current account, GDP and tertiary activity index could benefit from the recent yen weakness.

Commodity Currencies Rally as Carry Trades Resume Their Rise

The Australian, New Zealand and Canadian dollars were all up strongly today. With no Australian and New Zealand data released the rally has been predominately driven by demand for carry trades NZD/JPY is up a whopping 1.38 percent while AUD/JPY is up 1.12 percent. Even CAD/JPY managed to reverse earlier losses despite a much weaker Canadian employment figure. The market was originally looking for 19k jobs to be added to the economy in the month of April, but instead, the country shed 5.2k jobs. It is about time that we see the strength of the Canadian dollar have a detrimental impact on the economy. Meanwhile in the week ahead, New Zealand and Canada are both releasing retail sales and inflation data. Australia on the other hand only has housing finance and wage costs due for release.


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