Be Selective With Buying the US Dollar

May 2, 2008

Since the beginning of the week, I have warned of a potential dollar rally. At the time, we were basing our argument primarily on the flip in the FXCM Speculative Sentiment Index, technicals and a turn in Eurozone economic data.

However now we can add to that list a turn in US economic data as well. Throughout this past week, there have been a number of upside surprises in the US releases including today’s non-farm payrolls report, first quarter GDP, Chicago PMI, and manufacturing ISM. Although I do not believe that the worst is behind us, this stability does indicate that the pace of the slowdown in the US economy has moderated. This is the first time in 4 months that the non-farm payrolls report beat expectations, falling by -20k instead of the forecasted drop of -75k. Although the manufacturing sector continued to cut jobs, the service sector actually added jobs for the third month in a row, suggesting that Monday’s service sector ISM report may not be that bad.

For the Federal Reserve, this is a welcome improvement because it validates their hawkish comments and indicates that their efforts to date are mitigating some of the risks to economic activity. In addition to the NFP report, the Federal Reserve also announced additional liquidity measures. They increased the size of their Term Auction facilities from $50 billion to $75 billion, increased their swap lines with the ECB and SNB as well as expanded the collateral that they are willing to take to include AAA-rated asset backed securities. Up until today, the Fed was primarily accepting residential and commercial mortgage backed securities.

I expect a continued recovery in the US dollar, however traders need to be careful of what they buy.

In terms of US data, the economic calendar next week is light with only service sector ISM, pending home sales and the trade balance due for release.

The US dollar is nearing resistance against the Japanese Yen and there is little evidence to suggest that the currency pair will head much higher. The same can be said for the US dollar against the Australian dollar. Strong retail sales could continue to send the AUD/USD higher. However, the outlook is slightly different for the dollar against the Euro, British pound or New Zealand dollar. Fundamentals and technicals point to further losses for these 3 currencies against the US dollar.

Euro

The biggest event risk in the week ahead is the European Central Bank interest rate decision. The question before the markets is whether or not the ECB will acknowledge the recent deterioration in Eurozone economic data and as a result, take a step back from their staunchly hawkish monetary policy.

Unlike the US, Eurozone economic data has primarily surprised to the downside this week. German retail sales dropped for the second month in a row, the employment rate ticked higher, Eurozone industrial confidence deteriorated, Retail PMI across the region contracted while consumer prices showed a surprising drop last month. Manufacturing PMI numbers for the month of April was revised slightly lower for the Eurozone due to a slowdown in France and Italy.

However the only problem is that in recent weeks, members of the European Central Bank have not wavered. Today, ECB member Liikanen reminded the markets that controlling inflation is key.

The uncertainty surrounding the ECB interest rate decision should lead to some interest volatility following Trichet’s press conference at which everyone expects interest rates to be left unchanged.

Posted in ECB, US Dollar