Will the US Dollar Continue to Rally?

Nothing stopped the US dollar from raking in more gains today. The greenback extended higher as oil prices dropped below $125 a barrel and stock prices pushed higher. The Federal Reserve’s Beige Book report, which could have been a big market mover for the foreign exchange market proved to be a nonevent as the contents remain virtually unchanged from the prior report. Economic activity continues to be sluggish while price pressures are elevated or increasing, but weak demand has made it difficult for producers or vendors to raise prices. There is no threat of a rate hike or a rate cut by the Federal Reserve in the near future and that has left the US dollar at the whims of the stock and commodity markets. Although airline stocks have been the biggest beneficiaries of the correction in oil, businesses and consumers alike should relish in the stimulative effects of lower oil prices. The housing bill is moving its way through the House of Representatives. The White House has dropped its threat to veto the bill, helping to restore investor confidence. In case things get worse for Fannie or Freddie, the Treasury needs the powers to bail them out before Congress goes on recess in September. Despite the arguments against a bailout, Fannie and Freddie are too big to fail and the consequences would be crushing. Jobless claims and existing home sales are due for release tomorrow and in all likelihood, they will only have a limited impact on the US dollar. Instead, the greenback will continue to rally as long as oil prices push lower and stock prices move higher. Also keep an eye on gold prices because once the move in gold and the US dollar start diverging, it may provide the first sign of a top in the dollar. Since last Tuesday, gold prices have fallen more than $70 or 7 percent. The simultaneous rise in the US dollar, rise in stock prices and fall in gold prices confirm that the markets have grown less risk averse since the “twin twisters” of Fannie Mae and Freddie Mac first made landfall.

Euro Could Come Under Further Pressure on German IFO Report

Although dollar strength is the primary reason why the Euro is trading close to a 2 week low, it is starting to become very hard for Euro traders to escape the reality that the Eurozone economy is deteriorating. Eurozone industrial new orders plunged three times more than the market expected in the month of May as the strong euro and weak domestic demand makes life difficult for Eurozone manufacturers. Retail sales in France and Italy were also weaker than expected, which indicates that conditions there are not much better. As a result, we expect tomorrow’s German IFO report to be weak as these factors continue to weigh on German business confidence. The ECB’s commitment to fighting inflation will come back to haunt them as the economy continues to slow. According to ECB member Liebscher, the central bank is not worried. He said that growth will weaken but remain fairly healthy. In 2010 there should be a slight uptrend, which for many currency traders is the same as an eternity. Service and manufacturing PMI for the month of July will also be released tomorrow along with the current account figures for May.

British Pound: Retail Sales Will Determine Whether the GBP Can Hold Onto Gains

The surprisingly hawkish Bank of England minutes drove the British pound higher against all of the major currencies. The monetary policy committee voted 7-1-1 to keep interest rates unchanged last month. Although 2 dissenters were widely expected, no one believed that one of the dissenters would have favored a rate hike. Besley, broke from the mold to call for a 25bp rate hike to "to keep medium-term inflation expectations anchored and ensure the Committee's credibility." This three way split highlights how difficult monetary policy decisions have become for the Bank of England. Their problems are the same as everyone’s, albeit at a greater degree; inflation is hot, while growth is not. Retail sales are due for release tomorrow and they will play a big role in determining whether the British pound can hold onto its gains. The highest level of unemployment claims since the 1990s and the weakest level of consumer confidence in 28 years suggest that retail sales will have dropped significantly in the month of June.

USD/JPY Hits 3-Week High

The US dollar hit a 3 week high against the Japanese Yen. Oil prices fell $4 today which is positive not only for the US economy, but also for the Japanese economy. Since Japan imports close to 99 percent of their oil needs, the fall in oil prices could also help to boost domestic demand. The Dow Jones Industrial Average rose by a mere 29 points today, leaving some traders cautious of a near term top in US stocks. The fate of USD/JPY at this point is almost entirely contingent upon oil and stocks.

New Zealand Dollar Hits 6-Month Low After RBNZ Rate Cut

For the first time in 5 years, the Reserve Bank of New Zealand cut interest rates by 25bp to 8 percent and signaled that rates will be cut even further. The futures curve is pricing in 5 rate cuts over the next 12 months and this is the first of the five. The New Zealand economy has been struggling and could be headed for a recession. The dovish comments from RBNZ Bollard will keep the currency under water for some time. Meanwhile the Australian and Canadian dollars have failed to rally despite stronger than expected consumer prices. Their weakness is of course due to the drop in oil and gold prices. Like the rest of the world, inflation has hit Australia and Canada with food and energy prices on the rise. There is no more data from any of three commodity producing countries this week, which means that their fluctuations will largely be dependent upon on the fluctuations of commodity prices and the US dollar.

Kathy Lien is the Chief Currency Strategist at FXCM.