Yesterday’s less than inspiring testimony of Fed Chairman Ben Bernanke continued to weigh heavily on the greenback in overnight trade with euro benefiting the most from the anti-dollar flow. Dr. Bernanke’s candid comments regarding the state of the US housing sector (which he noted continued to slow due to lack of demand and more stringent credit criteria) knocked dollar bulls for a loop as it suggested the risk of further contraction for the US economy. Although the chairman reaffirmed his hawkish bias, in effect telegraphing to the market that short term rates were unlikely to be cut anytime soon, the Fed did lower its 2008 GDP forecast by 25bp from 2.75%-3.00% to 2.50%-2.75% range and that may have been the key factor in triggering a new round of dollar liquidation.

As we’ve noted before, at the present time, the EUR/USD trades not only on interest rate expectations but on growth differentials as well. As long as US growth continues to lag the pace of EZ expansion, the greenback is unlikely to sustain anything but a knee-jerk rally. That is why even a minor downward ratcheting of growth expectations by the Fed stopped any counter trend move by dollar longs dead in its tracks.

Nevertheless, we doubt that the EUR/USD could propel itself to the 1.4000 level on the back of the current data alone. The rise in the single currency is clearly having a deflationary impact on prices in the EZ. Today’s German Producer Prices are a case in point, having risen only 1.7% on a year over year basis – well below the ECB’s 2.00% barrier. As long as pricing pressures moderate, the ECB can remain stationary for much longer than the market anticipates, markedly slowing the pace of interest rate increases and dampening speculator appetite for additional EUR/USD longs.

The one currency that saw no benefit from anti-dollar sentiment was the GBP/USD. Cable dropped after UK retail sales numbers posted sub-par results and slower than expected M4 money supply growth. Higher interest rates are beginning to have their desired effect on consumption as UK retail sales grew only 0.2% vs. 0.4% the month prior. With UK consumer demand one of the most critical variables in BoE decision making process, tonight’s news suggests that the MPC is likely to remain neutral for at least several months forward, observing the reaction of the UK economy as it adjusts to the latest rate hike. In short 6% rates may have to wait until the end of 2007.

Boris Schlossberg is a Senior Currency Strategist at FXCM.