Tuesday, June 24, 2008

The Vulnerabilities of the US Dollar

- Euro: Headed Back to 1.60?
- Can the British Pound Hold Onto its Gains?

The Vulnerabilities of the US Dollar

The US dollar weakened significantly this past week as rising oil prices revealed the vulnerabilities of the US economy. Companies are beginning to struggle and have been forced to come up with more creative ways to deal with the energy crisis. With crude oil prices hitting $135 a barrel and gasoline in many states topping $4 a gallon, US companies are making cuts across the board. Ford Motors Co for example plans on reducing production while American Airlines will be lowering capacity by 15 percent and adding bag charges. According to the futures market, some traders even expect gas prices to hit $7 to $8 a gallon. However the US is not alone in having to deal with the oil crisis which is one of the major reasons why the dollar has weakened. Over the past few weeks, the market had been slowly pricing in a pause from the Federal Reserve. At the same time, there was a growing consensus that other central banks may need to begin or continue to cut interest rates. The surge in oil prices and hawkish comments from the European Central Bank, the Bank of England and the Reserve Bank of Australia dramatically altered the outlook for these central banks. With strict inflation targets, traders came to realize that interest rates for these 3 countries will remain unchanged for the foreseeable future and as a result, currency rates adjusted for these expectations. In the coming week, the vulnerabilities of the US economy may become even more apparent. The US markets are closed for Memorial Day on Monday, but we still have a busy week ahead of us with consumer confidence, new home sales, durable goods, first quarter GDP, personal income, personal spending and Chicago PMI due for release. We expect most of these numbers to be dollar bearish as US consumers continue to struggle under the weight of deteriorating personal finances.

Euro: Headed Back to 1.60?

The Euro staged a dramatic recovery against the US dollar this past week as hawkish comments from the European Central Bank fueled speculation that a rate hike may be around the corner. Although we think that a rate hike would be a dramatic move, the stability of recent Eurozone economic data is certainly encouraging as the market's focus shifts from fears for growth to inflation. Earlier this week, German business confidence for the month of May showed a surprising improvement. Today, the PMI numbers explain why German businesses are not worried. Service and manufacturing PMI numbers both deteriorated from the prior month, but remain in expansionary territory. Next week, it may be US rather than Eurozone economic data that help the EUR/USD inch towards 1.60. The only significant reports from the Eurozone are German employment, Retail PMI and German retail sales. We expect the labor market in Germany to continue to improve because the employment component of the manufacturing PMI report actually accelerated this month. Meanwhile it will also be a busy week for Switzerland who will be releasing their trade balance, UBS Consumption and KoF leading indicator reports. The currency has performed very well against the Japanese Yen this past week and it remains to be seen whether this strength can continue.

Can the British Pound Hold Onto its Gains?

It has been a great week for the British pound, which rallied more than 300 pips against the US dollar. Upside surprises in economic data as well as hawkish minutes from their latest monetary policy meeting confirmed that it will be months before we see another rate cut from the Bank of England. In fact, for all intents and purposes, the next move from the BoE may have to be a rate hike. Unlike the US, the Bank of England has a strict inflation target and if inflation is more than 3 percent, the central bank governor is forced to write a special letter to the Chancellor to explain why inflation has increased and to outline the time frame for bringing inflation back to target. Earlier this month, consumer prices hit 3 percent on a yearly basis, and now, the BoE must do all that they can to rein in inflation. The recent stability in economic data has helped their cause as long as the economy does not fall back into a downward spiral. With no major economic data due for release next week, the British pound stands a chance at holding onto its gains as long as there isn't surprisingly strong US data.

Great Week for the Australian, New Zealand and Canadian Dollars

Rising commodity has been the story of the week, helping to take the Australian, New Zealand and Canadian dollars higher. The Aussie rose to a 24 year high, putting itself within an arm's reach of hitting parity against the US dollar. Rising inflationary pressures and stronger economic data leaves the RBA far closer to a rate hike than any of the other major central banks. We do not believe that they are ready to raise rates, but tighter monetary policy could be a final option. The lack of meaningful economic data next week leaves the action for the Canadian and New Zealand dollars. Canada will be releasing its Current Account balance and GDP while New Zealand will be reporting its trade balance.

Fate of USDJPY Tied to Movements in the Dow

This past week, the fate of USD/JPY has been tied to the movements in the Dow but there has been vastly divergent behavior in all of the Yen crosses. EUR/JPY, AUD/JPY and CHF/JPY for example have performed well while USD/JPY has remained depressed. The sell of in US stocks continued to help the Yen, but the slew of market moving data scheduled for next week will heighten the event risks for the low yielding currency as we expected much of the data to reflect the pressure of rising oil prices. On the economic calendar are the retail sales, jobless rate, consumer prices and industrial production reports.


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