US Dollar: Running Out of Gas?
 
US economic news for last week was overwhelmingly positive with Consumer Confidence, ISM, GDP and most importantly NFP all printing at or above expectations, yet the dollar rally hit a wall. With market players now accustomed to nothing but good news from the US economy, the greenback will need better and better results to generate further gains. On the surface the dollar bulls argument couldn't be more clear: US economy is operating on all engines, Fed is going to 5% money and the greenback will continue to rise as higher yields attract more and more portfolio flows.

Looking underneath the hood however, there may be some cause for concern and most of it centers around housing. Irrespective of latest data, the housing market appears to be slowing. Existing Home Sales dropped from 7200K expected to 7090K and although much ballyhoo was made over the fact the New Home Sales jumped 13% from 1200K to 1424, as Barry Ritholtz properly pointed out the margin of error in the data sample was larger (17%) than the actual increase making the whole report highly suspect. Perhaps most trenchant dollar bear argument was made by a reader of Jack Crooks Black Swan newsletter who noted: “If I am correct, the average Joe is going to get so beaten up this winter by enormous heating bills, higher minimum credit card payments, and, in some cases, higher adjusted mortgage payments. Even Merrill Lynch sees it: They estimated that the first two of the three I listed might add as much as $700 to the monthly budget. Nobody earning $53K per year can absorb $700 per month without suffering a dire personal recession. Multiply that times 100 million households and you've got a mess. My prediction: Spring seasonal housing market opens and the buyers are no shows. Game over.”  The currency market may be thinking the same thing.

Euro Holds Support       

Well it wasn't pretty, but it got the job done. After more than two years of keeping rates steady, the ECB finally raised the repo rate by 25 basis points to 2.25% stemming the tide of ever growing interest rate differentials against the dollar. The manner in which the rate hike was made was hardly euro bullish, with Mr. Trichet essentially telegraphing to the market that the rate is likely to be a one off event. Nevertheless, combined with strong German Retail Sales data which increased 1.9% vs. 0.8% expected, the news last week kept the euro from sliding further with the single currency only losing 4 basis points against the buck. At this point it appears that EUR/USD may have found some support around the 1600-1650 region with many Central Banks sitting on the bid last week.

Next week PMI Services, Retail data and French Manufacturing should offer further clues to the direction of the unit with most analysts expecting relatively healthy results. Ultimately as we head into the close of the calendar year, the euro is unlikely to be propelled higher by any of its own fundamentals but will only gain ground in its traditional role as the anti-dollar if dollar worries return to the market.

Japanese Yen: To the Moon

How high can USD/JPY rise? Apparently to the moon. As we put the finishing touches on the report in early Monday Asia trade the pair has made new highs as 121.30 level, after blasting through the critical 120 barrier last week. Interest rate differentials continue to dog the pair especially with Japanese officials  content to let the currency devalue against the buck. Apparently the macro bet being made in Tokyo is that the country can withstand the higher dollar denominated crude costs in return for generating ever greater Trade Surpluses with US. Presently the Japanese are running a record $80 Billion trade surplus of goods. As General Glut wisely observes, “The chief problem for the yen is that the flattening of the US yield curve has made it uneconomical for Japanese investors to hedge their ongoing purchases of US Treasuries, but a falling yen encourages overseas investors to hedge their purchases of Japanese equities - negating the value of these latter flows in currency terms.” Thus explaining the recent market conundrum of rising Nikkei and falling yen. Still sooner or later push has to lead to shove, if for no other reason than the simple fact that dealers have had to inventory more and more yen the longer this rally has lasted. Interest rate differentials may continue to pressure the pair, but some sort of correction is way overdue.

British Pound Rallies on Poor Data

Looking at the right side of this page, one would hardly think that the pound was the strongest major against the dollar this week rising a full 106 basis points. With GFK Confidence and PMI Manufacturing all falling, the expectation would be that sterling weakness would persist. But a technical rebound along with relatively hawkish comments from Walton - one of MPC's more dovish members buoyed cable all week. Still BOE protestations of no more rate cuts for the near term aside, the jury is still out on the health of the UK economy.

This week's UK Industrial and Manufacturing data will be crucial to determining the possible direction of UK growth. Though the BOE is not expected to make any moves at its monthly meeting scheduled for  Thursday, if further signs of economic slowdown begin to show themselves in the next  few weeks, the pressure to ease on the UK Central Bank will become unbearable and in turn the pound may see more selling.  If however, demand stabilizes the pound with its 450 basis point yield may rally higher especially if capital begins to flow away from the greenback.

Swissie Ekes Out a Gain

More good news from Switzerland this week as GDP skyrocketed 2.3% vs. expectations of only 1% gain. The data confirms once again that Switzerland is outperforming EU and as a result the EUR/CHF continued to decline. However, with it ultra low rates the franc remains susceptible to carry trades and unless the SNB sends  a strong signal that it will begin tightening in 2006, the unit will continue to be  to vulnerable to portfolio flows.  Next week unemployment data is not expected to offer much of market moving news as traders will begin to shift more focus to the statements of various SNB members.

Boris Schlossberg is a Senior Currency Strategist at FXCM.