Dollar Strengthens But Is This Move Real?

DailyFx · November 15, 2007, 2:50pm

Euro: Becoming Overbought?
British Pound Extends Losses Following Retail Sales Numbers

[B]Dollar Strengthens But Is This Move Real?[/B]
The US dollar has strengthened against all of the high yielding currencies today, but have we seen the last of dollar weakness? Even though inflation and manufacturing data were decent, and gold prices plummeted as much as $30 intraday, the outlook for the US economy and US dollar still faces many risks. Consumer price growth was right in line with expectations but the fact that it did not surprise to the upside was disappointing enough. Manufacturing activity in the Empire State and Philadelphia region were stronger than expected, but this natural stimulus of dollar weakness has already been priced into the market. Jobless claims on the other were horrid, driving speculation that we could soon see a turn in the labor market. Troubles continue to plague the financial sector and US retailers are cautioning against a difficult holiday season due to higher food and energy costs and higher mortgage payments. The dollar is stronger today but that is primarily due to a sharp fall in commodity prices. The only thing that could save holiday spending for retailers is tourism. If Canadians and Europeans come to the US to do their holiday shopping, it would help to offset weaker domestic demand. Also, the dollar stands to suffer from reserve diversification. The central bank governor of the U.A.E said today that they may drop their dollar peg in favor of a currency basket including thee euro to contain inflation. Even though the reserves held by the U.A.E. are relatively small, if the move becomes official, it would be symbolically important because it suggests that other Gulf nations could follow suit. A rate cut by the Federal Reserve next month is still up in the air because the risks to growth are just as significant as the risks to inflation. We are expecting industrial production and the Treasury International Capital flow report on Friday; improvements are expected for both numbers.
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The Euro is losing steam and is failing to react to stronger economic data or hawkish ECB comments. This suggests that at least in the near term, the Euro is becoming overbought and in order for fresh gains to be achieved, we need to either see a big downward surprise in US data or a big upward surprise in European data. Unfortunately we will probably not get either of this tomorrow with the Eurozone trade and current account balances being the only pieces of Eurozone data on the calendar. Consumer prices were right in line with expectations; the 2.6 percent annualized pace of growth explains why the ECB remains extremely hawkish and refuses to talk down the Euro. Even the French are now convinced that the region needs a stronger currency. The Bank of France said this morning that inflation vigilance is warranted and the recent rise in the euro is helping to limit the rise in certain prices. According to the ECB monthly report, the central bank “stands ready to counter upside risks to price stability as required by our mandate.” We can’t imagine more hawkish comments than these. However the Euro has not strengthened and we think that this may be partially due to EURJPY selling. Meanwhile Switzerland will be reporting retail sales tomorrow. A tight labor market should lead to stronger spending.
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The British pound extended its losses today following weak retail sales numbers. Consumer spending dropped for the first time in six months during the month of October because of weaker food and clothing sales. Overall, the report highlights the Bank of England’s concerns that downside risks for growth loom large, especially after the central bank aggressively raised interest rates this year and as oil continues to trade near record highs. Furthermore, with the Bank of England’s inflation report suggesting that price pressures would rise in coming months, signs of an economic slowdown will only help build the case for a rate cut in Q1 2008. The Bank of England is notorious for shifting their monetary policy bias on a dime should data warrant it. Therefore a first quarter rate cut is becoming a realistic possibility.

The Australian, New Zealand and Canadian dollars are all significantly weaker today due to softer economic data and a sharp sell-off in gold prices. Other than the yellow metal becoming extremely overbought, there was no major behind today’s big move. Consumers are expecting less inflationary pressures in the month of November and even though weekly wages grew at a slower monthly rate in August, the annualized pace of growth increased. Meanwhile Canada is beginning to feel the strain of a stronger currency. Yesterday they reported weaker leading indicators and today they reported weaker manufacturing shipments. Only New Zealand has been reporting upside surprises in their economic data with business PMI increasing from 55.1 to 56.9.

The correlation between the global equities and EURJPY is estimated to be as high as 93 percent. The price action this week confirms that the correlation is very much intact with Dow strength on Monday leading to sharp gains and the corresponding weakness over the past 2 days leading to meaningful corrections. Even though Japan reported weaker a tertiary activity index, the market has stopped caring about Japanese economic data and comments from the central bank. This comes in stark contrast to the importance they give to US and UK data for example. The problem for Japan is that regardless of how much the central bank wants to lift interest rates, the economy is vulnerable to a significant slowdown because growth is concentrated in Tokyo while other regions of the country are still struggling. Therefore a rate hike in the near future is not a realistic possibility.

By Kathy Lien Chief Strategist of DailyFX.com