US Dollar: Bullish Break May Signal Additional Gains To Come

The US dollar rally continued on Thursday on speculation of the future direction of interest rates in the US, Euro-zone and UK. Indeed, the markets are now betting that the European Central Bank and Bank of England are likely to make their next policy move a rate cut. While we believe the Federal Reserve will not change rates before year-end, the simple shift in rate bets for the ECB and BOE are enough to underpin US dollar strength in light of the FOMC’s notation of significant upside inflation risks on Tuesday. From a technical perspective, we’ve seen EUR/USD and GBP/USD run into important support levels, but on the other hand, the Dollar Index has broken above the June 13 high of 74.30, suggesting the greenback’s rally on Thursday marks an important bullish break. That said, price action does not move in a straight line, and as a result I think the US dollar is more likely to consolidate its recent gains during Friday’s trading session, particularly since no key US data is on the calendar until next week.

Euro Pummeled as ECB Turns Attention to Downside Economic Risks

Despite an initial surge higher, the Euro tanked following the release of the European Central Bank’s rate decision. Indeed, the ECB left rates steady at 4.25 percent, but it was ECB President Jean-Claude Trichet who, as usual, proved to be more market-moving. Mr. Trichet said that recent economic data pointed toward "a weakening of real GDP growth in mid-2008" following strong growth during Q1, and with Euro-zone Q2 GDP scheduled to be released on August 14, there are concerns that the economy actually contracted. Meanwhile, the ECB remains particularly hawkish on inflation, saying that CPI would remain above 2 percent for "some time" and that recent data supported the latest rate hike in July. Since price stability is the ECB's primary mandate, the central bank will have limited ability to completely brush off the inflation data on hand in order to make monetary policy more accommodative due to an economic slowdown. Nevertheless, the markets have taken the bearish notes on growth to heart, as overnight index swaps are now pricing in 25bps worth of rate cuts within the next year, which is clearly to the detriment of the Euro. However, market expectations change and so can this speculation about interest rate reductions. Two key events that I think will be the most important for this include Euro-zone Q2 GDP next week and the release of the ECB’s growth and inflation forecasts in September. From a technical standpoint, EUR/USD is currently testing the 3/11, 5/8, and 6/12 lows near 1.5300. Given the extent of the recent declines (around 700 pips from the 7/15 record and over 200 pips since the start of the week), my bias is that EUR/USD should consolidate above 1.5300 in coming days, especially since there is no major European data scheduled for release on Friday. However, a break below this point would be indicative of sharper declines toward the 200 SMA at 1.5220 and the 50% fib of 1.4309 – 1.6036 at 1.5175.

British Pound Tumbles Despite BOE Decision To Leave Rates Steady – Why?

Looking at the British pound versus the US dollar on Thursday, one would think the Bank of England had surprisingly cut rates. However, this was not the case as the BOE left rates steady at 5.00 percent and did not issue a monetary policy statement, as expected. In fact, GBP/USD initially edged higher following the announcement, but it was a bout of US dollar strength following commentary by ECB President Trichet that really sparked the move. While we don’t have anything new to go on following the BOE meeting, overnight index swaps now show that the market anticipate 50bps worth of cuts within the next 12 months, and for good reason. While CPI remains well above the Monetary Policy Committee’s 2.0 percent target at 3.8 percent, business activity in the manufacturing, services, and construction sectors are all contracting, putting the UK economy at risk of recession. As a result, downside risks loom for the UK’s Bank Rate, and thus, the British pound. Nevertheless, with no UK data scheduled to be released on Friday, GBP/USD may simply consolidate above trendline support at 1.9400 for now, though a break below that level should target the March 2007 lows of 1.9185.

Commodity Dollars Down As Traders Continue To Sell High-Yielders

Weakness in commodities, risk aversion, and broad US dollar buying has weighed heavily on the high-yielding commodity dollars, including AUD/USD and NZD/USD. The Canadian dollar has not been immune either as the currency fell to 11-year lows versus the greenback on Thursday. Furthermore, declines for the Loonie may not be over yet as Canadian labor market data will be released. The Statistics Canada release of the net employment change is forecasted to rise by 5,000 while the unemployment rate is anticipated to hold at 6.2 percent. However, the employment component of the latest Ivey PMI report fell below 50 for the first time since December, indicating contraction. The last time this happened, the government release of the net employment change was surprisingly weak, and I think there is some potential for a similar disappointment on Friday. As a result, my fundamental bias for the Canadian dollar on Friday is bearish.

Japanese Yen Surges On Return To Risk Aversion

The Japanese yen rose across the majors on Thursday, though the low-yielder hardly budged versus the greenback, as traders sell high-yielding and risky assets. In fact, the same factors we mentioned above that are weighing on the commodity dollars are doing the exact opposite for the Japanese yen, and we’re seeing that the correlation between EUR/JPY and the DJIA is a bit better. That said, all of these assets are still essentially range trading and consolidating the larger moves from earlier in the year. **Something I’ve failed to note in recent days is that USD/JPY is the Japanese yen cross I watch most frequently, and thus, typically refer to in my analysis. However, there’s a clear divergence in trading of the yen versus the US dollar compared to the rest of the majors, and as a result, I will be sure to clarify my views going forward.

Kathy Lien is the Chief Currency Strategist at FXCM.