Is the Dollar's Recovery Here to Stay?
The US dollar hit a record low against the Euro this morning and came within striking distance of 100 against the Japanese Yen. However the new round of selling did not last long as the dollar quickly recovered its losses. US economic data was weak with the trade deficit increasing more than expected. Although the recent weakness of the US dollar led many people to believe that the trade deficit would narrow, we warned in yesterday’s Daily Fundamentals that the deficit could expand because of the deterioration in manufacturing ISM. Jobless claims improved but the Easter Calendar effect makes the number distorting, particularly since continuing claims remain at very high levels. Even US Treasury Secretary Paulson admitted that the economy has turned down sharply.

Unfortunately there is no concrete explanation for the bounce in the US dollar other than the fact that stocks are higher, commodity prices are lower and currency traders do not seem to be satisfied with Trichet’s comments. Whether this rally will continue remains to be seen.

Fundamentally, the US dollar should weaken further because retail sales, which are due on Monday, should contract for another month. However fundamentals do not seem to be the driving force behind the US dollar today as technicals and sentiment dominate. The triple top in the EUR/USD is looking particularly ugly and reminds us of the currency pair’s trading pattern between November and February, when it took the fourth test of 1.4968, the prior and 3 months before the currency pair managed to break 1.50. Therefore even though we still believe that the EUR/USD will break 1.60, a further correction before that happens would not be out of the ordinary. In fact, we expect import prices and the University of Michigan consumer confidence reports to be dollar positive because of the improvements in the weekly ABC consumer confidence reports and the sharp rise in commodity prices. As indicated by the leading story in today’s Wall Street Journal, inflation around the world is set to reach a decade high.

ECB Keeps Interest Rates at 4%, Trichet’s Hawkish Comments Not Convincing Enough for Euro Bulls
Euro bulls had big hopes for the ECB this morning when they drove the EUR/USD to a record high. However once the ECB rate decision rolled around, the Euro began to turn and the move exacerbated when Trichet started delivering his press conference. Although the central bank head told the markets that “the sentiment of the Governing Council is the same as last time, so if there is any interpretation that it goes in another direction, it is a wrong interpretation,” the price action in the EUR/USD suggests that traders believe otherwise. Combing the ECB introductory statement with a fine tooth comb, we see that the central bank is very uncomfortable with the current level of inflation. Growth is moderating and Trichet acknowledges it but the slowdown is not significant enough for them to even consider cutting interest rates. What is interesting however is the fact that Trichet used the words “price stability” only 7 times in his prepared statement compared to 8 times during the last 2 monetary policy press conferences. Are we reading too much into this? Perhaps, but if the US economy slows further, it will start to have a bigger drag on the Eurozone economy which may eventually force the ECB to tone down their hawkishness. In the meantime, economic data is still strong with the French industrial production and current accounts balance both beating expectations.

Bank of England Cuts 25bp, Balanced Statement
The Bank of England cut interest rates by 25bp to 5.00 percent. The statement was fairly balanced with the central bank concerned about mounting growth and inflation risks. The price action in the British pound following the rate decision illustrated the market’s confusion on how to interpret the BoE statement. The GBP/USD fluctuated within a 70 pip range for 3 hours before finally collapsing on broad dollar strength. The BoE rate decision must have been a tough one with inflation and growth both major concerns for the central bank. We will not get any further clarity on the tone of the meeting until the minutes are released on April 23rd.

Economic Data Fails to Impact Commodity Currencies
Weaker Australian employment numbers, New Zealand business PMI and a strong Canadian trade balance failed to impact the Australian, New Zealand and Canadian dollars. The Aussie and Kiwi resumed the rally that began at the beginning of the month while the Canadian dollar remained changed, having recovered earlier losses. The move in the commodity currencies were driven almost entirely by risk appetite and the rally in US stocks. Even though this should continue to play a role in the trading behavior of the comm. dollars, growth is beginning to weaken and that should eventually to a more meaningful in the Australian, New Zealand and Canadian dollars.

USD/JPY: Sharp Intraday Reversal
There was a strong intraday reversal in all of the Japanese Yen crosses thanks to the rally in US stocks and the US dollar. Despite the recovery, we believe that carry trades including USDJPY are vulnerable to more losses. It may not happen tomorrow, but it could very happen next week. The money markets indicate that risk aversion is returning with the spread between central bank and 3 month LIBOR rates climbing back towards the post Bear Stearns’ levels. Meanwhile Japanese economic data has been improving with machinery orders rising more than expected in the month of February.

Kathy Lien is the Chief Currency Strategist at FXCM.