Dollar Down on Delayed Response to Data

Talking Points

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The EUR/USD cleared the 1.2900 hurdle in early European trade for the first time in 10 days, as currency traders having comeback from the summertime weekend sold the greenback in a delayed response to dour US economic data on Friday.  The plunge in U of M  consumer sentiment readings, which slid to 78.7 from 84.7 in July caused US bond yields to fall, subsequently putting pressure on the dollar. Meanwhile, news from the Euro-zone was decidedly more positive with ECBs Weber predicting that German GDP growth will approach 2% this year while German Finance Ministry reported that July Federal State Tax revenues rose 11.5% on a year over year basis.  The growth in tax receipts suggests that the pace of business in Euro-zone largest economy has picked up markedly, but questions still remain whether this increase in economic activity is truly genuine or more a function of the one off demand spurred by the World Cup tournament. The next several months will tell if European recovery is sustainable.  

One possible source of worry is the continued strength in the EUR/JPY cross which could impact export growth to Asia. The cross reached all time highs once again tonight breaking the 149.00 barrier. The pair has been propelled by diverging interest rate expectations, with most traders expecting the BOJ to remain pat for the rest for the year while the ECB is forecast to raise rates another 50 basis points by end of 2006. With the ECB, the only major bank committed to monetary tightening, the EUR/JPY pair has benefited from the relentless buying by carry traders hoping to harvest the yield differential during the last few weeks of quiet summer trading.

However, the further this moves goes the more vulnerable it becomes to a sharp sell off. Latest IMM positioning shows euro longs maintaining very high levels at 90.2K contracts, and while that position can certainly grow larger, it is clearly approaching extreme levels. Furthermore, Japanese inflation data due out this Friday may finally force the countrys monetary officials to abandon their ultra cautious approach and consider another rate hike before the year end. While the 150.00 EUR/JPY level looms large and may just be too tempting to a stop hunt, the up move could end quickly if the market perceives even the slightest change in interest rate policies.  With Japanese government bonds yielding 1.800% - well below the key 2.00% psychological level yen bulls no doubt have a tough road to travel, but as EUR/JPY inexorably makes its way to 150.00 the possibility of a sharp correction becomes greater each day.

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