Watch for Surprises from the Bank of England

DailyFX Fundamentals 07-09-08

By Kathy Lien, Chief Strategist of DailyFX.com

What is slapping the US Dollar?

In a week devoid of any significantly market moving data, there has only been one clear factor driving the US dollar - stocks.

The dollar weakened across the board as stocks resumed their sell-off.

Its earnings season and warnings by analysts are slapping both equities and the US dollar.

Stocks are officially in a bear market, having fallen more than 20% since the October highs.

With many companies still set to release earnings, the general fear in the markets is that business conditions were weak in the past two quarters and will continue to remain difficult in the second half of the year.

Liquidation out of US stocks is triggering an overall liquidation out of the US dollars.

Unfortunately the greenback will probably continue to track the Dow for the remainder of the week.

Other than the trade balance and the University of Michigan Consumer Confidence report on Friday, there is no market moving data until next week. That will be when the action returns with retail sales, producer and consumer prices scheduled for release.

In the meantime, also keep an eye on crude prices. By now, everyone should realize that oil prices are determining monetary policy.

This is true for the US as well as other central banks around the world. Oil prices rebounded earlier today when Iran reportedly test fired nine missiles in the Persian Gulf and according to the Associated Press, the missiles could reach Israel, Turkey, the Arabian peninsula, Afghanistan and Pakistan.

These geopolitical tensions will probably ease as Iran's test fires prove to be nothing than muscle-flexing.

At that time, oil prices will continue to fall. Speculators are driving the move in oil prices and if the selling exacerbates, these traders will be quick to abandon their long positions.

Yesterday's drop in crude was the largest since 1991, but we could see another $10 drop in oil.

As indicated in these oil charts, between 2005 and 2008 oil prices corrected often and on average, the corrections ranged between 10% and 15%. Therefore oil could drop another $10 and still leave the long-term uptrend intact.

Watch for surprises from the Bank of England

The Bank of England is widely expected to leave interest rates unchanged tomorrow at 5% but currency traders should be prepared for any surprises.

Economic data has been very weak with the service, manufacturing and construction sectors contracting at the same time, which is the first in seven years.

The latest piece of bad news in a string of disappointments has the UK economy at risk of falling into a recession.

In the month of May, the visible trade balance narrowed from -GBP 7.527B to -GBP 7.494B. This was worse than the market expected, but the difference was not meaningful enough to impact the British pound.

Instead, the currency actually strengthened against the greenback, which struggled throughout the US trading session.

When the Bank of England leaves monetary policy unchanged, they usually do not release a statement. However they did in 2007, which means that it could happen again.

Meanwhile there is a tiny chance that the BoE could lower interest rates given the recent turn in growth - either way, any surprises would probably be pound bearish.

Euro: Shrugs off weak data

Despite weaker economic data and moderate comments from ECB President Trichet, the Euro strengthened against the US dollar.

First quarter GDP was revised down from 0.8% to 0.7%; the annualized pace of growth remained unchanged at 2.2%.

To put this number into perspective, the annualized pace of growth in the US during the first quarter was only 1.0%.

The German trade deficit also fell significantly due to a 3.2% drop in exports.

Spain could fall into a recession in the second half of the year, while Irish banks are warning about their own recession.

Not only will this drag down overall Eurozone growth, but it could also spillover into Germany and France. For these reasons, the European Central Bank refuses to commit to any monetary policy bias. This morning, ECB President Trichet defended their stance by saying that last week's hike was meant as a signal.

Canadian and New Zealand Dollars skyrocket, Aussie held back by employment numbers

The biggest story in the currency market today is undoubtedly the Canadian dollar which skyrocketed against all of the majors.

The Canadian dollar quietly gained strength going into the US trading session, but the rally took off after the housing market numbers, which were stronger than the market expected.

The New Zealand dollar also gained ground ahead of their business PMI numbers, which will be released this evening.

The Australian dollar on the other hand trailed behind as the sharp drop in consumer confidence (to 16 year lows) and the prospect of weaker employment numbers weighed on the currency.

Japanese Yen Crosses hit by 230 point plunge in the Dow

Japanese Yen crosses came under severe selling pressure on the heels of a major reversal in the Dow.

Economic data was better than expected with machine tool orders rising a whopping 10% in the month of May.

The market was only looking for a 1% rise, so the surprise was huge.

Looking ahead, Current Account and Trade Balance figures should have a significant impact on the currency, as the economy remains highly dependent on trade.

In addition, yearly Domestic CGPI figures are expected to increase on the back of high inflation. However the fate of the yen crosses will continue to largely depend upon the movements in equities. If the Nikkei follows the Dow lower tonight, we could see further weakness in USD/JPY.