Euro rebounds vs the Dollar, here's why

US Dollar

For our readers who were trading during the European session, the price action was extremely exciting as the EURUSD made a fresh 3 month high and then reversed the entire down move by the open of the US markets. Our US traders on the other hand contended with continued range trading as the dollar sold off in response to a combination of profit taking and bottom fishing by Euro bulls. US housing data released this morning for the month of September was very much in favor of a continued dollar rally with housing starts, building permits and mortgage applications all rising smartly.

However, as we have warned, the risk for a housing market slowdown grows as the market becomes even more overextended. The Beige Book report released yesterday validated our belief that the housing market is already beginning to slow with the New York, Boston, Chicago and Kansas City regions all reporting that homes either remained on the market for a longer period of time or that inventories were increasing. The report in general was slightly less optimistic than the market may have been expecting as the dollar continued to slide in the late afternoon session. Although all districts reported expanding activity, they also noted that the pace of growth was only “moderate or gradual” with local retail sales falling short of expectations and consumer confidence sliding.

However, by the same token, all of the districts also reported widespread increases in prices. Not only were gasoline prices higher but goods that may be indirectly affected by energy prices such as building materials and shipping have also increased. As a result, even though the outlook for the economy seems to be softer going into the November 1st FOMC meeting, inflation is still so much of a concern that the report did little to dent rate hike expectations. According to speeches by Fed Presidents Kohn and Pianalto, the rate hikes must go on. Kohn said that the Fed has not reached a point where they can stop raising rates while Pianalto confirmed that the central bank’s best policy is to keep raising interest rates gradually. Therefore any retracements in the dollar will probably me limited to the 1.2050 level against the Euro.

Euro

The Euro is rebounding as the market continues to ponder if the ECB will be delivering its first rate hike in over 2 years in 2006. This morning, an exceptionally strong Eurozone industrial production number helped the EUR/USD reverse earlier losses. Although activity in Germany contracted, improvements in France, Italy and Spain more than compensated for the difference.

Although any rate hikes will be done with caution, the ECB is already thinking ahead. Chief Economist Issing said yesterday that headline inflation was most likely going to sit above 2.00% for most of next year due to high oil prices. The June 2006 Euribor contracts are already gradually pricing in a higher possibility of a rate hike. As a result, the market is transfixed on when the central bank will makes it first move and if it really is next year whether it will come at a time when the Fed is ready to take a pause. If so, this could be extremely positive for the EUR/USD in 2006.

British Pound

The British pound was one of the market’s biggest movers yesterday as the currency pair shot higher. There has been a lot of volatility in the pound recently with daily ranges nearly double that of the Euro. The much-anticipated minutes from the October monetary policy meeting indicated that the committee voted 9-0 to keep rates on hold. The market had actually expected the vote to be split 8-1 with the dissenting voter favoring a rate cut, so the unanimous decision was taken as mildly hawkish.

The short-term outlook for growth and inflation remain unchanged, but some members felt that the risks for a weakness outweighed that of growth. Therefore the central bank still remains neutral with a slight dovish bias. BoE MPC member Lambert confirmed this bias when he said that the market may be “too optimistic” about growth and targeting for “too high” inflation. So for the time being, unless we have another major shock to the global economy, a stabilizing housing market as well as improving consumer spending could keep the central bank’s hands tied for the remainder of the year.

Japanese Yen

After coming just a hair shy of the 116 level, USD/JPY has spent most the day in the red as bulls take profits after this past week’s impressive rally. The dollar’s growing carry advantage seems to continue to favor the USD/JPY pair and the Japanese seem to have no problem watching their currency slide. Yesterday, Japan’s Chief Cabinet Secretary Hosoda said that he doesn’t think that the yen’s value is a big problem and that the Ministry of Finance is not considering intervention.

With the weaker currency stimulating the economy, the BoJ has no reason to want to step in yet. Meanwhile speculation for a rate hike next year by the BoJ was dealt a minor blow yesterday when Deputy Governor Iwata said that even if consumer prices move into the green next year, the central bank could leave its easier monetary policy intact. The Nikkei also dropped over 200 points overnight, suggesting that the stock market mania may be fading.

Kathy Lien

Kathy Lien is the Chief Currency Strategist at Forex Capital Markets. Kathy is responsible for providing research and analysis for DailyFX, including technical and fundamental research reports, market commentaries and trading strategies. A seasoned FX analyst and trader, prior to joining FXCM, Kathy was an Associate at JPMorgan Chase where she worked in Cross Markets and Foreign Exchange Trading.

Kathy has vast experience within the interbank market using both technical and fundamental analysis to trade FX spot and options. She also has experience trading a number of products outside of FX, including interest rate derivatives, bonds, equities, and futures. She has a Bachelors degree in Finance from New York University. Kathy has written for Stocks and Commodities, CBS Market Watch, ActiveTrader, Futures and SFO Magazine. She is frequently quoted on Bloomberg and Reuters and has taught seminars across the country. She has also hosted trader chats on EliteTrader, eSignal, and FXStreet, sharing her expertise in both technical and fundamental analysis.