NEWS / Government Ministries

Forex - Euro Breaks Out After Surprise Drop in Philly Fed

DailyFX Fundamentals 10-19-06

By Kathy Lien, Chief Strategist of www.dailyfx.com

??? Euro Breaks Out After Surprise Drop in Philly Fed
??? CAD Soars as Saudi Arabia Backs OPEC Cuts
??? Weak Retail Sales Has Limited Impact on British Pound

US Dollar

It has been an extremely exciting day in the currency markets as the breakouts that we have been waiting for in the EUR/USD and USD/CHF finally materialize. The combination of a weak leading indicator report and Philadelphia Fed survey has sent the dollar tumbling. Leading indicators rose by a less than expected 0.1 percent in the month of September while the Philadelphia Fed survey of manufacturing conditions shocked traders by falling for the second month in a row to a fresh 2.5 year low. With the market accentuating its reaction to negative US data and minimizing its reaction to positive data, the double blow from today??™s reports was exactly what the EUR/USD needed to break higher. As we have warned yesterday, the tight consolidation that we have been seeing foreshadowed a sharp break. Although the US dollar could recuperate some of its losses with no data is due for release tomorrow, 1.25 in the EUR/USD has become a hard cement floor that is be extremely difficult to break. The recent reports that we have seen suggest that we could still see slowing in the US economy over the next few months, with the manufacturing sector particularly vulnerable. Even the first ever close above 12,000 in the Dow Jones Industrial Average failed to help the US dollar. Instead, traders latched onto the Saudi and Venezuelan support of the recent OPEC cuts and warning of more to come if oil prices do not budge by sending the Canadian dollar to the highest level in a week. If oil prices creep back above $60 a barrel, it will be perceived as a negative development for the US and in effect, create more downward pressure on the US dollar.

Euro

After being yesterday??™s quietest currency pair, the EUR/USD was the day??™s second biggest market mover, behind USD/CHF. European economic data was disappointing this morning, but that did not matter as the disappointments in the US were even more unexpected. Producer prices in Germany fell 0.3 percent in the month of September, led by the drop in energy prices. The French current account deficit was also larger than expected, but the real surprise was from Italy. Even though industrial orders were stronger in the month of August, rating agency Fitch downgraded Italy??™s credit rating from AA to AA minus with a negative outlook. They were worried about growth and the strains the country would have to undergo to bring down the deficit. Despite the rather grim reports, ECB members continue to be very hawkish as council member Gonzalez-Paramo reiterated the central bank??™s familiar message of keeping a tight leash on inflation today. We are certain that the central bank will bring rates up by another quarter point by year end, especially with the recent weakness in the Euro making it easier for the central bank to tighten monetary policy. The only question is, will there be more after that. So far, economic data suggests otherwise, but it is all dependent upon whether inflation picks up in the months ahead.

British Pound

The British pound extended its gains after a brief pause yesterday despite mixed economic data. Retail sales took a turn for the worse and actually fell by 0.4 percent in the month of September. The market was looking for a 0.4 percent rise given the strength of recent economic data, but with wage growth squeezed by rising inflation, consumer spending was not able to hold up. Although the index is generally volatile, the recent surprise rate hike by the central bank appears to have hurt consumers. We are expecting the first release of third quarter GDP tomorrow and judging from today??™s report, growth should have slowed in the third quarter. Yet not all news was bad news. Money supply as well as public finances and borrowing all increased more than expected in the month of September. One retail sales release is not enough for us to back away from the more optimistic outlook that we have had on the UK economy as of late.

Japanese Yen

Unsurprisingly, the performance of the Japanese Yen has been very mixed today. There was no economic data released last night and only comments from Bank of Japan Governor Fukui who said nothing interesting about the economy or monetary policy. He will be speaking again tonight and we expect the same sort of message from the central banker. Traders are still worried about the potential for another nuclear test by North Korea. This worry is becoming more real as South Korea warns of another 3 to 4 nuclear test from now on. China has also condemned the tests and it appears that they too are putting pressure on North Korea to not add fuel to fire that is brewing in the global community. Meanwhile Japan has reported the third consecutive week of net foreign inflows, which is not surprising given the recent ???cheapness??? of the yen. We suspect more investors are looking to join Russia in adding to yen exposure over the next few months. However further gains in USD/JPY will be contingent upon more dollar weakness than yen strength at this point.