Why Did the Dollar Rally?
The first day of trading in the second quarter has been positive for both the US equity market and the US dollar. Investors that have cut back on dollar denominated holdings in the Q1 are jumping back in force with Lehman Brothers raising $4 billion from a stock sale to calm investors and UBS announcing a similar plan to replenish capital. The US dollar is up across the board while the Dow Jones Industrial Average surged close to 400 points. On a percentage basis, this is the strongest start to the second quarter in 70 years and the improvement in risk appetite is the main reason for the dollar’s recovery.

Manufacturing sector ISM was stronger than expected, but it remained in contractionary levels, which means that the data does alone would not have triggered today’s dollar rally. Prices paid surged to the highest level in 2 years, which is the only other reason for dollar strength.

Inflation is roaring its ugly head with gas prices hitting a record high and rice prices estimated to rise by 55 percent this year according to the World Bank. This leaves Bernanke in a tough spot ahead of tomorrow’s testimony before the Joint Economic Committee. Although Big Ben will most certainly face tough criticism about the current state of the US economy, he has to decide whether greater emphasis should be placed on growth or inflation. How much longer can he turn a blind eye?

Growth in the US is still a serious problem, but the continual rise in food prices also puts pressure on the pocketbooks of US consumers. The dollar should resume its slide if Bernanke puts a greater emphasis on growth, but if he stresses the need to balance inflation with growth, the odds for a 25bp rate cut will increase significantly, extending the dollar’s rise. The futures market is currently pricing in an 80 percent chance that the Federal Reserve will only cut interest rates by 25bp at the end of the month compared to a 20 percent chance of a 50bp cut. In addition to Bernanke’s speech, we are also expecting the ADP Employment and the Challenger Layoff reports. These numbers will help to determine if March will be another month of weak non-farm payrolls growth.

Euro Breaks Down as Cracks Begin to Show
The Euro dropped over 200 pips today following a much weaker than expected German retail sales report. For the past few months, the EUR/USD has rallied on hawkish comments from the ECB and economic data supporting the central bank’s stance. However today the cracks are seriously beginning to show which has many traders wondering whether we could see a more meaningful sell-off in the Euro. Consumer spending in Germany dropped by the largest amount in 13 months as rising food and energy prices cut spending. Although manufacturing PMI in Germany increased, the same numbers for France and Italy fell more materially.

The continual improvement in the German labor market failed to offset the disappointing consumer spending numbers. Meanwhile Deutsche Bank, Germany’s largest bank announced that they will write down $3.9 billion. This number pales in comparison to UBS’ $11.9 billion loss which is why EURCHF rallied over 150 pips today. On top of the big UBS announcement, service sector PMI was also weaker than expected, reflecting deteriorating conditions in Switzerland.

British Pound: UK Manufacturing Rebounds, Prices Hit 9-Year High
Despite the gloomy outlook for the UK economy, manufacturing activity accelerated in the month of March. The US dollar has weakened significantly against the British pound over the past few months but the pound’s weakness against the Euro has helped to offset the slowdown in US demand. Employment increased modestly but prices hit a 9 year high indicating that manufacturers are passing on their costs to consumers.
This explains why the Bank of England is so concerned about inflation.

Another rate cut this month will be a close call as inflationary pressures bump heads with deteriorating growth; Consumer prices are well above the Bank of England’s 2 percent target while house prices are at
12 year lows.

Australian Dollar Plummets, New Zealand and Canadian Dollars Recover
The Canadian and New Zealand dollars recovered on the back of today’s improvement in risk appetite. Canadian raw material and industrial product prices were weaker than expected, but these numbers were not particularly market moving. The Australian dollar should have also recovered but dovish comments from the Reserve Bank kept the currency under pressure throughout the day. The RBA left interest rates unchanged at 7.25 percent, which was no surprise, but Stevens said that the central bank’s monetary policy will cool demand growth which will help ease inflation. Although prices have climbed significantly over the past few weeks, Stevens expects prices to fall over time.

Japanese Business Confidence Hits 4-Year Low
A sharp deterioration in Japanese Business Confidence drove the Japanese Yen to a 2.5 week low against the US dollar. The triple blow of slowing US growth, rising oil prices and a strong Yen forced businesses to become even more cautious about the outlook for the Japanese economy. Goldman Sachs argues that this pace is equal to the pace that was seen in the past recession. Although growth is deteriorating, there is still a next to zero chance of a rate cut from the Bank of Japan. Interest rates are already at 0.5 percent and the BoJ does not have significant room to ease monetary policy. Looking ahead, we expect the BoJ to become even more pessimistic about the outlook for growth, but as usual that may only have a limited impact on the Japanese Yen as risk appetite remains the currency’s dominant driver.

Kathy Lien is the Chief Currency Strategist at FXCM.