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Meltdown in the Euro

- US Dollar: Strongest Rally in 2 Years - Meltdown in the Euro - British Pound Sinks to 2 Month Lows

DailyFX Fundamentals 12-14-2007

By Kathy Lien, Chief Strategist of DailyFX.com

US Dollar: Strongest Rally in 2 Years
Today we had the strongest one day rally in the US dollar against the Euro since May 2005. A number of factors can be attributed to the move such as strong consumer prices, Lufthansa’s purchase of a stake in JetBlue and overall risk aversion. However it is important to realize that the rally began at the European open and only exacerbated after the US numbers. The tide turned for the dollar yesterday when producer prices and retail sales came out much stronger than expected. Consumer prices only validated the strong inflationary pressures that we all know the US economy faces. For the Federal Reserve, this means that they will need to continue to be nimble with interest rate cuts, but at the same time they can also put an increasing focus on consumer spending because oil prices have come off its highs reducing the risk of further upside price pressure. The most important thing is that the consumer is not giving up which reduces any chance of a recession next year. Also, we are beginning to hear good news related to the financial sector. Lehman Brothers reported better than expected fourth quarter results while Citigroup announced plans to rescue seven affiliated investment funds. Looking ahead the dollar could continue to rally as year end position unwinding takes hold of the markets. A lot of money has been made going short dollars this year, particularly against the Euro. This latest breakdown makes the idea of booking profits now rather than later increasingly attractive. There are a lot of US economic releases scheduled for next week, but we consider most of them Tier 2 data, meaning that their market moving potential and impact on the Fed’s future interest rate decisions are minimal. These include the current account, Empire and Philly Fed manufacturing indices, the TIC data, the final figures of third quarter GDP, personal income and personal spending.

Meltdown in the Euro
Since the beginning of the month, the Euro has been trading in a 1.4525 to 1.4790 trading range. Today the currency has finally broken out of that range but to the surprise of many traders, the dollar strengthened instead of weakened. Everything from statistical analysis to fundamentals predicted dollar weakness over strength but perhaps that one sided signal is the exact reason why we had such a big move in the EUR/USD today. Headline Eurozone consumer prices were stronger than expected, growing by 3.1 percent last month, while core price growth remained unchanged at 1.9 percent. Unlike the Federal Reserve, the ECB thinks that headline prices are just as important as core prices which mean the ECB will continue to remain hawkish. To some degree, this is old news which is why the Euro did not react to the data. Instead, everyone is focused on what to do with their positions before the end of the year. The German IFO report, producer prices and Eurozone PMI are the most important releases on the Eurozone calendar next week. We expect all of the numbers to be Euro positive, but be careful of just trading the event risk because sentiment seems to be dominant driver of market activity at the moment.

British Pound Sinks to 2 Month Lows
This week, the lack of meaningful UK economic data made the British pound completely vulnerable to dollar strength and weakness. Today was a perfect example of that dynamic as the pound came under pressure from nothing other than dollar buying. Next week, the tables should turn as we expect much more important UK numbers. The data on the UK calendar includes consumer prices, the minutes from the last monetary policy meeting, the current account balance, mortgage approvals, money supply and retail sales. The Bank of England minutes will be particularly interesting because even though the BoE lowered interest rates for the first in 2 years earlier this month, the statement was not dovish. The fate of the British pound will be dependent upon how soon the BoE will cut interest rates again, if at all. Keep an eye on the voting record because a small majority in favor of the rate cut would signal a nice pause before the next move while a unanimous vote would boost expectations for another rate cut in January.

US Equities Erase Gain, Taking Carry Trades Down With It
Over the past two trading days, US equities have struggled to gain ground and failed to do so despite a groundbreaking announcement by central banks around the world. Today the bulls have finally given up, paving the way for stocks to close at a weekly low. Even though the Tankan report last night was much weaker than expected, Yen weakness was only sustained against the US dollar. Instead, risk appetite once again dominated Yen trading erasing all of the prior gains in the Yen crosses. The big event risk next week is the Bank of Japan interest rate decision – unfortunately, we do not expect much volatility from the decision because the BoJ has and will continue to leave interest rates unchanged for the foreseeable future.

Continued Weakness in the Australian, New Zealand and Canadian Dollars
The Australian, New Zealand and Canadian dollars continued to sell-off today despite the lack of meaningful economic data. This was due entirely to dollar strength and general liquidation out of high yielding currencies. Next week, the commodity currencies could finally get a life of their own thanks to a heavy economic calendar. We are expecting the minutes from the last Reserve Bank of Australia monetary policy meeting, the New Zealand current account balance, third quarter GDP and Canadian consumer prices. We expect most of these event risks to be negative for the commodity currencies which goes in the line with the current technical outlook for these pairs. Support has been broken which suggests further losses.