Euro Returns to 1.4700, Double Top or New Highs?

[B]Talking Points[/B]

• Australian Dollar: Westpac confidence at 11 month low but Aussie recovers on carry
• Pound: Takes out 2.08 as labor data proves favorable
• Euro: Within a striking distance of 1.4700 as GDP growth snaps back
• US Dollar: Retail Sales on tap

EURUSD continued its climb in overnight trade making its way back to the 1.4700 level, boosted by supportive global equity price action which spurred the return of the carry trade flows in the currency market. As the Nikkei, Footsie and Dax all rallied in the wake of yesterday 300+ gain in the Dow, risk appetite returned prompting traders to once again put on the carry trades which were liquidated just a few days ago.

The euro was also helped by the relatively strong GDP data out of the EZ as Q3 numbers printed at 0.7% vs. 0.6% expected - more than twice the growth rate of Q2. The news suggested that the region’s expansion remains robust with corporate investment responsible for the bulk of the improvement in data.

Whether the region can maintain this steady pace of growth remains to be seen. Many analysts believe that the high cost of energy and record high exchange rate will weigh down on EZ performance in 2008. Even the European Commission reduced its expectations next year from 2.5% to 2.2% given these factors. However, euro strength has served to offset the high energy costs to some extent while industrial production has been able to adapt to the higher exchange rate regime with minimal impact on growth. That dynamic may changing, as the latest EZ data points to more serious slowdown in the manufacturing sector, but for now the performance of the EZ economy appears solid and the market continues to give the currency the benefit of the doubt expecting further rate hikes from the ECB.

In UK however, those hopes were dashed tonight, after the BoE released its inflation report noting that risks were skewed to the downside. Furthermore, the UK central bank noted that it expects rates to be at 5.5% in Q1 and 5.1% before the year end suggesting that it will begin a lowering cycle in 2008. Cable bulls who expected the UK central bank to remain stationary were gravely disappointed and the unit made a complete about face dropping more than 200 points in less than a hour as a result.

It is interesting to note that while Q3 EZ GDP growth was respectable it was still 120 basis points lower than US GDP in Q3. However, the currency markets are focused interest rate differentials rather than relative growth rates. With most traders convinced that the Fed will be forced lower rates in December the pressure on the dollar remains severe. To that end, today’s US Retail Sales could help shape those expectations either way. The bear case for the greenback rests on the assumption that the US consumer will slow down materially in the next several months prompting the Fed to continue easing. If the data surprises to the upside, it may put the whole notion of December Fed rate cut into doubt, and that in turn may put a cap on EURUSD rally.