Dollar Sells Off as Weak Data Puts to Question Bernanke's Optimism (page 1 of 2)

US Dollar

On the first day of trading in the month of April, we have seen quite a bit of volatility in the currency market. The dollar had a very mixed day against the majors as it lost strength versus the Euro, British pound and Japanese Yen, but gained strength against the commodity currencies (AUD, NZD and CAD).

The sell off against the majors took off after the much weaker than expected Institute of Supply Management report. The manufacturing sector is showing signs of waning strength with the ISM index falling from 56.7 to 55.2 last month. Although this still suggests that the sector is expanding, traders were really hoping for activity to accelerate and were forecasting for the ISM index to rise to 57.7. Ahead of this Friday's non-farm payrolls report, the dip in the employment index was also worrisome.

After last Tuesday's hawkish FOMC statement, the market was really looking for the stronger data to back up Bernanke's view that the slowdown in the fourth quarter was only "temporary." However, with manufacturing activity weakening and the housing market delivering yet another piece of bad news, traders began to doubt the new Fed Chairman's optimism.

According to the National Association of Realtors, pending home sales fell 0.8 percent in February. This follows the 10.5 percent drop in new home sales reported last week. Although construction spending ticked higher, it remains questionable how much longer this can be sustained with interest rates driving mortgage rates higher. Not all news was bad news today however.

The prices paid component of the ISM report jumped to 66.5 from 60.9 indicating that inflation is still prevalent, giving the Fed a good reason to continue increasing interest rates. However, even so the turn in the dollar is significant and we expect more weakness than strength in the days to come. Meanwhile the commodity currencies are seeing a strong liquidation. The New Zealand dollar continues to be hit with the unwinding of long term carry trades. The Australian dollar has sold off in sympathy.

Euro

The Euro gained strength today primarily on the back of dollar weakness, but the rise in the region's manufacturing sector purchasing manager's index also instilled a bit of confidence in the Euro itself. Economic growth continues to improve in the region with German, French and Italian manufacturing activity all accelerating last month.

In fact, activity in Germany jumped from 55.8 to 58.1, a 5.5 year high. Despite strikes in France, activity increased from 52.2 to 54.6 while Italy, the usual laggard, also saw its manufacturing index rise from 55.1 to 55.5. We are expecting a lot of data from the Eurozone this week, most of which are expected to highlight improving economic activity.

Even so, the market is expecting the European Central Bank to leave interest rates unchanged this Thursday. Although ECB officials have been extremely hawkish and most analysts are calling for three to four more rate hikes this year, the actual bouts of tightening are predicted to come in a more orderly manner - once every quarter for the next three quarters.

The reason for the more tempered rise comes off of the ECB's fear of causing a sharp rally in the Euro by being too aggressive. The central bank knows that much of the region's recovery has come from the weakness in their currency and they will take active measures to prevent excessive strength.

However even if the central bank leaves interest rates unchanged, that will not prevent them from making more hawkish comments which could still keep the Euro lifted.