Market Opinion Foreign Exchange

Market Opinion
Foreign Exchange
USD Hits Resistance

The dollar correction that we spoke of last week did not show signs of materialising until Friday, and now looks set to play out. Instead, EUR/USD decided to have another go at the all-important 1.1900 level, before bouncing back to 1.2070. A move above 1.2100, which appears likely, presages a further rally to the 1.2200 level, a break of which could even see gains towards the major 1.2350 area.

Weak US consumer sentiment, benign core inflation and a drop in US industrial production in September weighed on the dollar, causing a re-think by the foreign exchange market, with many participants perhaps have been gunning for a break of 1.1900 and 115.00 for USD/JPY. On the euro side of the equation, French CPI rose to 2.2% y-o-y in September, while Irish CPI jumped to 2.8% y-o-y last month. Both numbers mean that the final E12 CPI released on Tuesday could even be revised up from the 2.5% estimate, which would likely trigger further hawkish comments from ECB members. In addition, the euro may receive a positive boost from the German political scene. Although, the grand coalition is obviously not the best of news for Germany, the appointment of Peer Steinbrueck as Finance Minister could have been worse, given his generally pro-business and pro-reform stance.

Clutching at euro straws? Well, yes, really, but we do believe in a short-term euro bounce. Beyond the near-term, though, regular readers will know that we are not likely to give up on the dollar so easily, on which we have been bullish since above 1.2800. Despite the negative effects of Hurricane Katrina, revealed in last week’s data releases, US real GDP is likely to grow by around 3.5% in 2005, with only a mild slowdown anticipated for next year. Indeed, growth should still rise by more than 3.0% in 2006 - depending on oil prices, and the extent of the Fed’s tightening policy. Compare this to euroland. The IMF recently downgraded its 2005 growth forecast for the region to 1.2%, and expects a real GDP growth figure of 1.8% in 2006, well below that forecast in the US. That said, we would be amazed if this latter number turned out to be correct, given the overall lack of reform in Europe, and the poor levels of domestic demand and employment. Indeed, we fail to understand why euroland growth would jump so much while the rest of the G7 experiences an oil-induced slowdown. An oil price shock would hit euroland just as hard. As a result, we believe that 1.1900 will eventually give way, once this period of correction is over.

So, what about USD/JPY and GBP/USD. Well, we maintain the short-term view of last week, that both the yen and sterling can correct higher, possibly even as far as the 111.00 area for USD/JPY and 1.8100-1.8200 for cable. However, beyond this technical correction, we feel that USD/JPY will re-test and eventually break the 115.00 level over coming weeks, as the ever-increasing carry (3.75% at present) will persuade investors to favour the dollar. As for sterling, one of the key reasons for holding the currency in recent times has been the attractive interest rate on offer. Yet as the differential between US and UK rates narrows, which we think high likely, and possibly even favours the dollar at some point in 2006, we see absolutely no reason for holding sterling. All the more so when one looks at the outlook for UK real GDP growth, which continues to disappoint on the downside. This creates more problems for Chancellor Brown, and probably means more taxes, or more borrowing.

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