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Why the Euro Has Rallied

- US Dollar Sells Off as the Outlook for the Economy Worsens - British Pound Extends Gains on Inflation Fears

DailyFX Fundamentals 05-21-08

By Kathy Lien, Chief Strategist of DailyFX.com

US Dollar sells off as the outlook for the economy worsens

The US dollar weakened across the board today as stronger economic data from around the world highlighted the underperformance of the US economy.

Australian, German, Canadian and New Zealand economic data all surprised to the upside while MBA mortgage applications, which was the only number released from the US dropped 7.8% to match its year to date low.

Despite the recent stability of US economic data, the outlook for the economy is still bleak. According to the minutes from the latest Federal Reserve meeting, the Federal Reserve expects unemployment to increase significantly and growth to be much weaker than the January estimate.

There are also little signs that the housing market is bottoming and any recovery could be fragile. Yet interestingly enough, the Fed still expects growth to rebound in the second half of the year.

Their hope is that the stimulus checks and their more than 300bp of easing will finally hit the US economy.

At the same time, inflation is becoming a growing problem, so much that the decision to cut by 25bp in April was a ‘close call.’In other words, the Federal Reserve is done with cutting interest rates.

If they considered leaving rates unchanged last month, then there is nearly 100% chance they will pause in June.

Fed fund futures are currently pricing in a 90% chance that rates will stay at 2.00% next month. These hawkish comments triggered a sharp wave of weakness in US equities that dragged nearly all of the carry trades lower.

Tomorrow we are expecting jobless claims and the house price index. House prices in particular should be weak because they reflect the health of the most vulnerable parts of the US economy.

There have been reports that home equity lines have been frozen or reduced by many banks. This could hurt the housing market even further by forcing the cancellation of many transactions.

Why the Euro has rallied

Hawkish comments from the European Central Bank last Thursday cemented the near term bottom in the Euro.

Yesterday, the currency broke out of its month long trading range against the US dollar on the stronger than expected growth in German producer prices and the prediction by the President of the ZEW that the ECB could raise interest rates.

Today, these hawkish comments were validated by the rise in German business confidence. Both the current and expectations component of the IFO report increased this month, which suggests that the strength of the Euro and the weakness in the global economy is not taking a significant a toll on German business activity.

Whether this strength is more than just fluke remains to be seen as Friday’s PMI numbers will shed more light on the actual health of the Eurozone economy.

Meanwhile the Swiss Franc also rallied across the board thanks to a drop in the unemployment rate and an improvement in analyst pessimism. During periods of carry trade liquidation, the Franc performs particularly well.

Sterling extends gains on inflation fears

The pound extended its gains on the combination of broad dollar weakness and inflation fears.

The Bank of England released the minutes from their monetary policy meeting earlier this month and according to the report, fears of inflation will keep the central bank on hold for the foreseeable future.

Eight out of the nine members voted in favour of the decision to keep interest rates un

changed with the dissenter favouring a rate cut. With a strict mandate to focus on inflation and two members already voting to keep rates unchanged at the prior meeting, the near unanimous voting record was not all that surprising.

Although the need to focus on inflation and the problems with price pressures is a sentiment shared by all of the MPC members, the internal outlook for growth varied.

Some members felt that the economy is holding up well, while others believed that a more serious downturn may be right around the corner. Either way, their hands are tied because consumer prices are already at their pain threshold of 3%.

Retail sales and the CBI industrial trends survey are due for release tomorrow. If consumer spending falls for another month, the uptrend in the GBP/USD could come to an end.

Uptrend in the Canadian, Australian, and New Zealand Dollar continues

The rally in the Canadian, Australian and New Zealand dollar has continued thanks to the combination of stronger economic data and US dollar weakness.

The Aussie hit a new 24 year high and we believe that it is on its way to parity. Just 5 months ago, the AUD/USD was trading at 88 cents and now 800 pips or 9% later, parity is within reach.

Consumer confidence jumped 2.7% this month from a 15 year low thanks to the record income tax cuts announced by the Treasury. All this needs to do is translates into stronger consumer spending and parity will be reached.

Meanwhile the Canadian dollar benefitted from hot consumer prices, the new high in oil prices and the first rise in leading indicators in 3 months.

If retail sales also beat expectations, the Canadian dollar could test its year to date high. Although the New Zealand dollar primarily strengthened on its correlation with the other commodity producer currencies, it too benefitted from a sharp increase in credit card spending last month.

USD/JPY: Headed lower

Over the past 2 trading days, US stocks have plunged more than 400 points. The currency pair that has been hurt the most by this move is USD/JPY, which has now broken its 2 month trend line.

Further losses are in store for this pair, particularly if existing home sales fall short of expectations on Friday. The merchandise trade balance and the all-industry activity index are due for release this evening. Higher oil prices should increase the country’s import bill, reducing the trade surplus in the process.