Monday, August 11, 2008

08/11/2008 09:17 AM

Dollar Rebound: Careful What you Wish For

The dollar had pushed to fresh 5-month highs of $1.4910 against the euro in overnight Asian trade before retreating back to $1.5050s as oil prices rebound to $115.95 per barrel on the escalating conflict in South Ossetia. The dollar pullback was broad, while sterling bounced off its 21-month lows against despite an unexpected 0.6% decline in UK PPI. Although the dollar has dragged the euro below the psychologically important $1.50 figure for the first time since late February, the first technically important support level stands at $1.4910-20, which coincides with today’s low. We mentioned in Friday’s note that the $1.49 figure is equivalent to 2% below the 200-day moving average. The last time the euro broke more than 2% below its 200 –day moving average was in 2005—when the fundamentals had temporarily moved in favor of the US currency.

In order for the dollar to garner further upside momentum, the following must happen (in order of importance):

1. U.S. fundamentals show convincing signs of a turnaround (peaking unemployment, bottoming housing and rebounding consumer demand/retail sales).
2. Deepening weakness in the Eurozone coupled with signs of peaking inflation.
3. Evident signs of stability on the US banking front to the extent of reviving foreign interest in US banking stocks and Agency bonds. US stocks rally must also be accompanied by higher volumes, which has not been the case as of late.

Careful What You Wish For

The main advantage of a rebounding dollar has long been associated with falling oil prices and a reduction in the inflationary escalation of rising commodities in and out of the US. But is the emerging global economic weakness and increased signs of demand destruction that have been instrumental in lowering oil prices, alongside the supply increases from Saudi Arabia. Therefore, the combination of deepening weakness in Europe and Asia coupled with an appreciating US currency may jeopardize any hopes of a decent US recovery, especially if protracted dollar strength erodes the vital contribution from net US exports (exports minus imports) on US GDP growth.

The chart below shows that next exports have been the largest contribution to US growth in the last five quarters, with investment in the red and consumption weakening. As personal consumption expenditure (PCE) weakens further following the fading of the stimulus package, the positive effect from the trade gap takes on a more significant role. A 6-8% appreciation in the dollar from these levels will increase chances of a double hump formation in US GDP growth.

EURUSD Remains Above Key Support

EURUSD proves it could hold above the $1.4910-20 territory, but a renewed attempt to break the $1.49 figure cannot be ruled out with fresh evidence of a slowing Eurozone. Thursday’s release of German Q2 GDP is expected to show a slowdown to 1.7% from 2.6%, while Eurozone CPI is expected to be confirmed at a 4.1% annual increase in July. Key support stands at $1.4700, which is the trend line support extending from the $1.43 low and onto the 1.4360 low. Upside capped at $1.5150, followed by $1.52

USDJPY Drops Back Below 110

the dollar’s retreat from its 110.40 high to 109.70 has been accompanied by the oil-driven dollar pullback, but emerging weakness from Japan may support the pair at 109. Only renewed bout of reduced risk appetite is expected to accelerate the yen’s appreciation, particularly against the USD, GBP, CAD and NZD. As far as equities are concerned, we stick with our forecast for a top in 1,320 and 11,900 in S&P500 and the Dow respectively.

Sterling Relief Seen Temporary

Sterling’s rebound against the dollar shows more lasting than the recovery on EURGBP. The unexpected 0.6% decline in UK PPI may signal the peak of factory inflation, which could have a dampening on consumer inflation in the medium term. Since inflation has been the only obstacle to rate cuts from the Bank of England, any prolonged evidence of peaking CPI is considered as an overwhelming negative for GBP. Cable’s latest tumble to 21-month lows is expected to resume later this month. $1.9020 stands as the 200-week moving average, which is expected to be called up before month end. Long term objective stands at 1.78.

Analyst Bio

Ashraf Laidi, Chief FX Analyst at CMC Markets, oversees the analysis and forecasting functions of key currency pairs as well as decisions and trends of the major global central banks. Mr. Laidi is also responsible for education and informing clients on the essential dynamics underpinning FX markets.

Prior to joining CMC, Mr. Laidi has worked for such varied organizations as the United Nations, the World Bank, and Reuters. Mr. Laidi regularly provides expert opinion to various electronic, print and the broadcast media outlets.

Mr. Laidi has appeared regularly on CNBC-TV, Bloomberg TV, the BBC and PBS’ Nightly Business Report. His insights also appear in the Financial Times, The Wall Street Journal, Barron’s, The New York Times, CBS Marketwatch, TheStreet.com, Futures Magazine and a host of other international publication.