Why today could make or break the US Dollar

Yesterday, we said that it was very likely the market was too optimistic on
the potential contents of Iran’s letter. If anything, “concessions by Iran in
the letter could be minimal and it is even possible that the solution they are
proposing involves the US backing off more than Iran itself. “ Today, the US
revealed that the letter from the Iranian President was far from diplomatic.
According to reports, Iran criticized the US for its policies and offered little
solutions. More letters are expected to other heads of state, which only means
that tensions with Iran will continue to remain on the lips and fingertips of
all traders.

The US dollar has sold off as it erases all of yesterday’s gains against the
majors as oil prices resume their climb. Gold prices also hit $700 for the first
time in 25 years. If today’s two major events prove to be dollar negative as
well, we expect to see fresh year to date highs in the Euro, Japanese Yen, Swiss
Franc, Australian and Canadian dollars. In order for both events to be dollar
negative, we would need to see the US Treasury brand China as a currency
manipulator and more neutral comments from the US Federal Reserve, suggesting
that the Fed will really be closing the door on further rate hikes. If both of
these unfold, we could easily see a 200 point move in the EUR/USD. In contrast,
if the Fed leaves most of the FOMC statement unchanged and the US Treasury does
not brand China as a currency manipulator, we expect to see a relief rally in
the US dollar.

But what about the middle ground? Everyone seems to be talking about either the
black or white scenario, but it is just as likely for the US Treasury to tighten
up their stance on China without labeling them outright. The last report
published in November 2005 applauded China for the changes that they made to
their currency regime last July. At the time, they said that because of the
move, they refrained from designating China as a currency manipulator. So who is
to say that rather than doing a complete about face, the US Treasury would not
choose to revert back to the comments they made in May 2005. They could just as
easily acknowledge China’s steps towards moving to a more flexible system, but
criticize them for not doing enough and repeat that if they do not substantially
alter their policies soon, they would meet the Treasury’s technical requirements
for being designated as a currency manipulator. The US Treasury’s report comes
at a sensitive time politically where the US has an interest in drumming Chinese
support for a strategy in dealing with Iran.

Remember, the report is just as much political as it is economic. Therefore,
harshening their stance on China’s policies without out rightly branding them
yet may be a good middle ground for the US at this point. As for the Federal
Reserve, tomorrow could also be a critical turning point in the monetary policy.
According to a study that we conducted in 2005, any “pauses” after a prolonged
tightening and easing cycle tend to lead to sharp moves in the US dollar. We
have already seen the greenback sell off on speculation that the Fed may be
done, therefore if they officially move to neutral, losses in the dollar could
be exacerbated. However, since the market is extremely bearish dollars at the
moment, anything to the contrary will probably lead to a sharp dollar recovery.

The Euro is stronger today climbing just shy of its yearly highs as the
outlook for the US dollar worsens. Even though there are some very important
pieces of Eurozone economic data due for release tomorrow including German trade
reports and French industrial production, the US dollar will undoubtedly drive
market price action. Today is a perfect example of this dynamic as traders
completely shrugged off a surprisingly weak German industrial production report.
In the month of March, manufacturing activity saw its biggest decline in seven
years. Falling 2.4 percent on a monthly basis, construction activity was the
primary source of weakness as output among builders dropped by 15 percent. Cold
weather and high oil prices are weighing on the Eurozone’s largest economy which
should temper some of the hawkishness that we have recently been hearing from
Eurozone central bankers.

British Pound

Led higher by dollar weakness, the British pound is trading less than 40 points
away from its 12 month highs against the US dollar. The Bank of England is
scheduled to release their much anticipated Quarterly Inflation report tomorrow
morning. As we have been mentioning, the market expects the central bank to
raise their inflation forecasts. The producer price figures released yesterday
confirm that inflation pressures are rising. Furthermore, consumer prices have
remained above their 2 percent target throughout the forecast period. If the BoE
delivers what the market expects, we will probably see a modest rise in the
British pound since much of it has already been priced in. On the flip side, if
they fail to do so, expect a sharp sell-off in the British pound. Dollar factors
will dominate trading today so any weakness would probably be best expressed in
EUR/GBP.

Meanwhile, there is news that UK Prime Minister Tony Blair may step down next
year. According to the UK Telegraph, Blair said that he may not go to the end of
his term. He added that if he did step down, he would give his successor who he
has anointed as Gordon Brown ample time to establish himself before the next
elections. One of the Members of Parliament present at Blair’s speech predicted
that he would hand over the job to Brown at the party’s conference in the autumn
of 2007. The changing of the guard in the UK will probably be taken as a
positive development since the market holds high regards for Brown and it also
puts an end to Blair’s low approval ratings.