Market Opinion - Foreign Exchange... Data Good for Dollar?:
Data Good For Dollar As expected, the euro did not collapse last week, and in fact rallied in line with our short-term view. The move back through 1.2000 saw EUR/USD bounce swiftly to a high of 1.2256. Enter some really positive US data, which gave support to the dollar and ensures that the US Fed funds rate is still heading higher from its current level of 3.25%. This sentiment was underlined by Philadelphia Federal Reserve President Santomero, who stated that the FOMC must stay ahead of the curve in fighting inflationary pressures. In addition, Richmond Fed President Lacker declared that it was too early to foresee a pause in the removal of monetary accommodation. For the moment, though, inflation seems to be under control. Producer prices in June were unchanged on the month, compared to expectations of a 0.4% rise, while the core component, excluding food and energy costs, actually fell by 0.1% m-o-m. Core CPI rose by just 0.1% m-o-m. However, economic activity continues apace. Retail sales jumped by 1.7% in June, after declining by 0.3% in May, as rising incomes due to the improving labour market are helping to offset the negative impact of increased gasoline prices. The University of Michigan consumer sentiment index came in at 96.5, compared with expectations for a reading of 95.0. In addition, June industrial production increased by 0.9%, with the manufacturing component rising by 0.4%, highlighting a clear improvement in this sector of the economy. Perhaps the most encouraging news for the dollar, though, was the decline in the US trade deficit to US$55.3bn in May, from US$56.9bn in April. The 0.1% rise in exports to US$106.9bn is encouraging for Q205 real GDP, which is forecast to grow by 3.5%, versus 3.8% in Q1. The trade deficit with China, however, continues to widen, registering a huge shortfall of US$72.5bn year-to-date. This will undoubtedly heighten the political pressure on China to revalue the yuan. We still see no hurry on the part of the Chinese authorities to bow to such pressure, as we said back on January 23 in our article No Move For China FX. As for the overall US trade deficit, its size is still of course a concern, and dollar bears are correct to argue this point. Yet, so long as foreign investors are willing to purchase US assets and property, its financing is not a major problem just yet. In contrast, the case for the euro rests on shaky foundations. The ECB is unwilling to lower interest rates to stimulate growth, bemoaning instead the lack of structural reform, and stressing a desire to maintain price stability. Whilst the reform issue is a problem, inflation is not a key concern, despite the negative effects of higher oil prices and a weaker euro. On the reform front, there is hope that a victorious Angela Merkel of the Christian Democratic Union (CDU) at the upcoming German elections will be true to her word. Last week she unveiled business-friendly plans to cut labour costs and ease hiring and firing regulations. For the sake of the euroland economy, and indeed global trade, this would be a big step in the right direction. Much depends, naturally, on the size of her potential victory and whether the CDU gain a sufficient majority to be able to pass such laws with minimal opposition. For now, this is all conjecture, and without evidence of clear action on structural reform, talk is somewhat cheap. Ok, so what about the direction of EUR/USD. Well, interestingly the strength of the US data did not overly boost the dollar, revealing again the importance of this 1.1800-1.2000 area. As such, we could well see further price consolidation in this region. In fact, we still like the technical view of a long-term head and shoulders pattern - with the right shoulder currently being established - which suggests an eventual break of the 1.1800 neckline and an exchange rate closer to 1.0000 over the next 12-18 months. As we have been saying for a while now, the interest rate differential will become ever more favourable for the dollar, and once the hedge fund industry starts playing the euro carry trade in earnest, the exchange rate is only going one way. .
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