US Dollar: A Chink in The Armor

The dollar finally fell against the euro for the first time in 4 weeks and the key catalyst for the decline, was the statement by ECB chief Jean-Paul Trichet that the European central bank was finally ready to raise rates. The news, late Friday afternoon galvanized the fixed income markets compressing interest rates differentials between US treasuries and German Bunds which in turn of course sent the euro skyward. 

Interest rate differentials of course have been the key driver behind  greenback's rise in 2005 but that theme may be finally wearing out. Although most of the US eco data was rather positive last week most notably the whopping TICS number which printed 101.9B vs. 75B expected the unit failed to get much traction past the 1.1650 level. The FX market may already be looking towards 2006 with some traders anticipating a marked slowdown in US growth and consequently the end of the rate tightening policy.  The one piece of data that received little coverage but may portend ominous developments for the dollar was Friday's report from Gap that pre-Christmas sales were slow.  The stock dropped 10% off the announcement and if it is emblematic of the general retail environment, the dollar may soon follow in the same
direction.  

Euro: Relief Rally

With political turmoil in France finally under control for the time being the market turned its attention back to economic issues. Our long held argument that the way to the higher euro was first through a lower euro appeared to have been confirmed, as the lower exchange rates led to better than expected growth in the export driven Euro-zone. Both German and French GDP numbers beat their expectations and the projection for EZ growth for 2006 was bumped to 2.3% from this year's anemic 1.3% rate. The net effect of this improved economic tone was the announcement late Friday by Trichet that rates after a near 3 year hiatus will finally be marked up by 25bp at the December meeting.

Though the interest rate differential between the dollar and the euro still remains at a substantial 175bp spread, the tide for long suffering euro longs may be finally turning. If the Fed begins to slow down its tightening policy while the ECB proceeds to curb liquidity as we move into 2006, the shift in trader sentiment will become palpable. However,
it is far too premature for euro bulls to celebrate. The best that can be said is that the patient has stopped bleeding.

Japeanse Yen: Yen Top Part 2

Perhaps the best reason to be bullish yen right now is that almost nobody shares that view. According to our proprietary SSI index the ratio of longs to shorts has finally reached parity after an unbelievable long and incredible painful journey over the past few months when most of the speculators tried in vain to pick a top in the pair with ratios often skewing to 4 yen longs to 1 dollar long positioning.  Having been destroyed both by the carry costs and the capital losses, yen bulls may have finally capitulated.

Still the economic backdrop for the currency remained muddled with Current Account data registering terrific surpluses but other gauges such a consumer sentiment and industrial production showing a slowdown in growth. Combine that with adamant adherence to zero rate interest policy and an unlikely move much lower in crude, given the return of the cold weather to Europe and North America, and it is difficult to see what will trigger a yen rally. Our best idea last week was the long EUR/JPY as a play on interest expectations and the cross did indeed rally past the 140 mark.

Next week however, with holidays in US, the action in USD/JPY appears to be extremely difficult to handicap with the key driver of sentiment most likely to be the inflation numbers as the end of the week. If Tokyo CPI does indeed perk up above expectations perhaps it will begin to change the Japanese governments unwavering commitment to the zero interest rate monetary policy. 

British Pound: Cable Collapses

The saga of collapsing cable continued last week as the unit reached yearly lows dropping past the 1.7100 figure. For the week the unit lost 142 basis point against the buck * the worst performance amongst the majors. The precipitating event was a rather dovish report from BOE suggesting that inflation risks were "balanced".  Those words coming from the generally hawkish central bank, spooked most currency traders as fears of another BOE rate hike mounted. However, the week's economic news was relatively upbeat with Retail Sales actually rising 0.2% and the RICS housing survey showing the smallest rate of decrease in 18 months. For the time being the UK economy appears to have stabilized, though signs of weakness still persist, most clearly in the claimant count numbers which rose to 12.1K from 5K expected.

Next week the calendar is muted with only the Industrial trends survey and the GDP release likely to make any splash in the market. Having been so grossly oversold, starling is due for a rebound, especially if we see some dollar long liquidation. However any bounce in the unit is likely to be of the dead cat variety.

Swiss Franc: Gooooooooooold!

The most interesting currency story of last week wasn't even in the majors. The old relic * gold had a breakout rally as it nearly hit the $500 mark. But as has been the case for most of the year the Swissie did not follow. Though the safe haven currency used to be a terrific proxy for gold in the FX market, that correlation as completely disappeared this year after Switzerland changed its long standing policy of backing 40% of the unit with gold reserves.

Though it can no longer be considered "liquid gold" the franc still retains its status as safe haven currency.  With turmoil in France subsiding and interest rate differentials between Europe and Switzerland widening out the Swissie lost 50 basis against the euro this week. But if the SNB follows through on its promise to tighten in December, the cross may once again become an attractive sell above the 1.5500 level.

Boris Schlossberg is a Senior Currency Strategist at FXCM.