Why Is The Dollar So Strong?
Friday morning February 1 appeared to be an ideal time to be a dollar bear. The EUR/USD was trading near the 1.4900 level, itching to make a run at the key psychological 1.5000 figure. The just-released news of a sharp contraction in Non-Farm payrolls – the first negative reading in more that four years – was a stark confirmation that the US economy was on the verge of tipping into a recession. Coming as it did only two days after a very weak US Q4 GDP number, the dour employment data suggested that the Fed will have to continue easing rates for the foreseeable future.

Getting Stopped Out
With euro already enjoying a 100bp interest rate differential against the dollar and with the prospect of that interest rate spread widening even further, the path of least resistance in the pair appeared to be up. 1.5000 was within grasp. Many traders including yours truly plowed into a long EUR/USD position right after the NFP news and promptly got stopped out. Incredulous, and chalking up the initial price action to mere profit taking, I soon re-entered the long EUR/USD only to be stopped out again 12 hours later.

Data Points to US Recession
After the second loss, I paused and let reason control my stubbornness and began to wonder – why is the dollar so strong? Fundamentally there are many reasons to be dollar bearish, not the least of which was yesterday’s shockingly weak ISM Non Manufacturing number. ISM No Manufacturing printed at 44.6 – well below the 50 boom/bust line -as every major component of the report from new orders, to employment, to business activity contracted sharply. The news practically assured further Fed easing, perhaps by as much as 50bp at the next FOMC meeting in March.

Although the EZ PMI data last night also showed serious deterioration in demand, suggesting that US economic slowdown may be spreading across the Atlantic, the fact of the matter is that ECB, even if it chooses to lower rates will do so much more gradually than the Fed and the interest rate differential between the two currencies is likely to widen as the 2008 progresses. On the surface, this dynamic should provide fuel for further EUR/USD rally. Yet price of the EUR/USD continues to go down. In technical parlance, the pair has traced out a reversal candle on Friday, having failed to break above the 1.4950 level for the third time in a row in the past three months. That area now represents a cement ceiling for the EUR/USD and the euro will need to re-build some serious momentum before it can make an assault on new highs again.

Many Theories, Few Clear Reasons
What’s behind the dollar rally? There are many theories, but few clear reasons. Often the reasons for such market moves become obvious only in retrospect. Analysts have speculated on everything from the notion that ECB’s hawkish intransigence will actually result in a much more severe contraction in EZ than the US, to the idea that Fed aggressive actions will spur a resurgence of US growth in H2 of 2008. Regardless of the economic possibilities, traders would be well heeled to listen to the advice of Mark B. Fisher, who in his book, “The Logical Trader” noted,

“If a market is making a substantial move and traders seem to understand why, this market trend is not going to last very long. However, if the market is moving in one direction and nobody has a clue as to why, then the trend is going to be prolonged. When a market goes up or down for no apparent reason, it tends to go a lot further in that direction than people can imagine.”

All of the traders probing for a bottom in this most recent down leg of the EUR/USD may want to consider those words carefully. While the data continues to point to further EUR/USD strength, the price refuses to confirm this analysis and as traders we should respect the message that price is sending.

Boris Schlossberg is a Senior Currency Strategist at FXCM.