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Euro Retreats After Hitting a Record High of 1.6019

- US Dollar Falls to a Record Low, Driving Oil Prices Toward $120 - Bank of Canada Cuts Interest Rates by 50bp, Signals More to Come

US Dollar falls to record low
It has been a record breaking day in the financial markets with the US dollar falling to a new all-time low and oil prices hitting a record high above $119 a barrel.

When it comes to oil and the US dollar, it is difficult to determine which is the primary driver because the dollar’s weakness pushes oil prices higher while oil prices hurts the outlook for the US economy. Although it can be argued that higher crude prices are inflationary, it is not that simple because the Federal Reserve cannot raise interest rates to combat inflation.

With the market already pricing in only a quarter point rate cut, to forgo a rate cut completely would send a message to the markets that the Federal Reserve is not quite ready for. At this time, the Fed’s bigger problem is the pressure that $5 gas prices may have on consumer spending and corporate profitability.

The pocketbooks of US consumers are getting pinched by the day as prices rise globally. This morning, there have been reports that Mattel is raising toy prices and even the MTA (Metropolitan Transportation Authority) here in NY is planning to raise the price of alcohol, soda and snacks for the first the first time in 4 years; the price hike of 25% is by no means shallow.

Housing market numbers were released this morning and they were not as bad as analysts had feared. The absolute number of existing homes sold was slightly more than expected even though the drop on a percentage basis was greater. House prices actually ticked higher which is a relief for the housing market even though that relief will probably be temporary. California just reported the highest level of mortgage defaults in 15 years, reflecting the severity of the problems in the US real estate market. Expect the US economy to get worse before it gets better.

Euro retreats after record high
The fourth time is the charm for the Euro as it finally pierces the 1.6019 level against the US dollar. Despite slightly better than expected existing home sales in the US, a rebound in house prices, and news that the German Banking Association bailed out Duesseldorfer Hypothekenbank AG after a string of mortgage losses, the market refuses to give up its voracious appetite for Euros.

This continual rise in inflationary pressures raises the risk of a rate hike from the European Central Bank. This morning, ECB member Noyer said that the central bank will do what is needed to control inflation, including raising interest rates. Although he tried to temper that comment by saying that rates are currently appropriate, the seed has been planted. Tomorrow’s service and manufacturing PMI numbers will shed more light on how well the Eurozone economy is holding up given current market conditions.

Interestingly enough, there are not as many option barriers according to the volatility smile at 1.60 as there was at 1.50. This suggests that extension may not be as high. When the Euro broke 1.50 it rallied another 144 pips on the very same day and then added 300 pips over the next few weeks with virtually no retracement. Therefore the power of the move above 1.60 will not be as strong as the move above 1.50. In fact, 1.60 could even be a near term top.

Bank of Canada rates cut signals more to come
For the second time in a row, the Bank of Canada cut interest rates by 50bp. This is the most aggressive move that we have seen from the central bank since September 11th.

The CAD dropped like a hard rock following the rate decision because not only did the BoC cut rates, but they also warned of more to come. Weaker growth domestically, fears of further spillover effects from the US economy as well as tight credit conditions are the central bank’s primary concerns.

The only reason why the CAD reversed its move was because of the rise in oil. Sooner or later Canadian fundamentals will come back to the forefront. Retail sales are due for release tomorrow and we expect them to be weak given the sharp decline in wholesale sales. Meanwhile, Australia will be reporting consumer prices. After the hottest producer price growth in 10 years, consumer prices should also follow suit.

Sterling sells off following BoE Announcement
Fresh from yesterday’s trading loss, on the back of rising criticism about the Bank of England’s (BOE) GBP50 billion swap, the British Pound regained posture against the US Dollar, rallying by 150 pips. In light of the Royal Bank of Scotland’s $24 billion sell of shares and the BoE’s attempt to increase liquidity in order to boost the ailing housing market, speculations run rampant that the worst is yet to come for the once resilient UK economy.

Today, Finance Minister Alistair Darling is set to meet with key mortgage lenders, in hopes of convincing them to cut costs of home loans and find ways of helping people refinance their mortgages. Investors eagerly await this month’s central bank minutes set to release on Wednesday, in hopes of finding a silver lining, in terms of a future rate cut. As the economy trudges along, it remains to be seen what sorts of surprises the government pulls out of its black hat, but it can be assumed that it will be awhile before the UK economy start chugging smoothly.

Japanese Yen holds onto Dollar gains
The Japanese Yen continued its lead against the US Dollar, as investors ushered in positive economic release from the world’s second largest economy. Supermarket sales figures rose for the second month in a row, due to rising food costs, causing investors to remain optimistic about future growth prospects.

With Democratic Party Japan pushing for higher minimum wages, and the retention of the gasoline tax cut beyond April, expect consumer spending to recover, which could help Japan revive at a quicker pace than expected. Looking ahead, Merchandise Trade Balance and CPI figures should help the Yen gain against major currencies.