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3 Reasons Why the Euro Weakened

- US Dollar's Recovery Does Not Equal a Bottom - 3 Reasons Why the Euro Weakened - Is the British Pound Making a Near Term Bottom?

DailyFX Fundamentals 01-16-08

By Kathy Lien, Chief Strategist of DailyFX.com

US Dollar’s Recovery Does Not Equal a Bottom

We are finally seeing cohesive price action in the currency markets as the US dollar recovered against every major currency. Stronger economic data has curbed expectations for a 75bp rate cut, leaving 50bp of easing the only realistic possibility. Unlike producer prices, consumer price growth was stronger than expected last month with the annualized pace of core prices rising from 2.3 to 2.4 percent. Industrial production was flat and net foreign demand for US securities increased $90.9 billion in November. Although both numbers represented a slowdown from the prior month, they soundly beat market expectations. Even the Beige book report contained silver linings. The various Fed districts acknowledged the weakness of holiday sales, but on balance, they all felt that economic activity has increased modestly and the labor market remains tight. With this in mind, it will certainly be interesting to see if Federal Reserve Chairman Ben Bernanke shifts his tone at tomorrow’s Congressional testimony. The last time he spoke, Bernanke was decidedly bearish, triggering a sharp sell-off in the US dollar. In addition to the comments from the Fed Chairman, we are also expecting housing starts, building permits and the Philadelphia Fed manufacturing index. These are the most vulnerable sectors of the US economy which suggests a slim chance for dollar positive numbers. Although we still believe that the US needs a 75bp rate cut, Bernanke lacks the shock factor of some of his predecessors which means that 50bp is all that we will most likely get. However even if 50bp is under delivering, it is important to realize that this would take US rates down to 3.75 percent, which is 25bp less than the Eurozone’s interest rates and 50bp less than Canadian rates. Therefore when the “cross” happens, we could actually see the EUR/USD rally and USD/CAD sell-off as funds that only hold interest bearing positions readjust their exposure.

3 Reasons Why the Euro Weakened

This morning, the Euro fell 200 against the US dollar pips in less than 2 hours and remained weak throughout the US trading session. The lack of breaking news at the time made it difficult to pinpoint one single factor that drove the currency pair lower. Instead, we attributed the move to a combination of developments. The most widely credited reason for the selloff was the dovish comments from ECB member Mersch. He said that the Euro’s gains were dampening growth and he urged the ECB to be cautious given uncertainties and look through temporary inflation jumps. The biggest reason why his comments were so important is because Mersch is traditionally a hawk, which means that he has shifted his stance. Although this is a factor for the Euro’s decline, we are not sure if his language was strong enough to warrant a 200 pip slide, especially since ECB member Weber reiterated his hawkish comments an hour before Mersch spoke. Strong US economic data is the second reason why the Euro dropped. The third is a fall in commodity prices, which could soften the blow to US consumer demand in the coming months and reduce the pressure on the ECB to raise interest rates. Tomorrow, we are expecting the ECB’s monthly report and the Eurozone Trade Balance. None of these numbers should be particularly market moving.

Is the British Pound Making a Near Term Bottom?

Although the British pound ended the US trading session flat against the US dollar, the currency pair recovered strongly against the Euro, Japanese Yen and Swiss Franc. UK jobless claims dropped more than expected in December while earnings including bonuses held steady. This is encouraging for the pound because it suggests that the financial sector troubles have not translated to massive layoffs in the UK. The RICS house price balance was the weakest since the early 1990s house price crash but the problems in the UK housing are already priced into the British pound. There are no UK economic numbers due for release over the next 24 hours which suggests that a further bounce may be possible. Our Technical Analyst Jamie Saettele believes that we will see an explosion higher in the GBPUSD. Read our GBPUSD Bottom Report for more details.

Australian, New Zealand and Canadian Dollars Continue to Weaken

Broad dollar strength and falling commodity prices have pushed the Australian, New Zealand and Canadian dollars lower. New Zealand consumer prices rose by 3.2 percent on an annualized basis in the fourth quarter, which was stronger than expected, but that has failed to lift the Kiwi. Australia will be releasing its labor market report this evening. Although it may be difficult to match the healthy numbers reported in November, we still believe that Australia will report solid job growth. Later in the day, Canada will be releasing their report of international securities transactions. Foreign purchases of Canadian securities dropped significantly in the month of November, so a rebound is expected.

Carry Trades See Sharp Intraday Reversal

Sharp volatility in the stock market has triggered sharp moves in carry trades. Most of the Japanese Yen crosses fell to fresh lows in early European trading but they managed to recover all of those losses and then some throughout late European and US trading sessions. Japanese economic data was mixed with machine orders and CGPI beating expectations but the trade numbers fell short of expectations. The recent Yen strength is expected to take a big toll on exports. Last year, Japanese automaker Toyota unseated Ford as the world’s number 2 automaker by sales. If the Yen remains strong, we would not be surprise to see Ford steal the title back from Toyota in 2008.