Gain Capital

The USD is closing lower on the week against all non-JPY currencies, in line with last week’s observation of a breakdown in the USD index. The USD closed slightly firmer against the JPY, which translates into yet another new high for the JPY-crosses and the carry trade in general. The dollar selling got off to a quick start on Monday and minor new lows were made subsequently. Interestingly enough, positive US economic data at the end of the week sparked only a minimal rebound in the USD. (ISM non-manufacturing rose to 60.7 from 59.7, a 14 month high, and June NFP beat market forecasts, though somewhat below ADP-inspired expectations of 150+, but strong revisions to the prior two months data more than made up). The better US data sent benchmark 10 year Treasury note yields up nearly 20 bps from the week’s low, which led to a slight widening in the US interest rate advantage against the EUR, and yet the dollar remained heavy. Persistent USD weakness in the face of the better than expected data and higher rates suggests there is a larger wave of USD selling going through the market and this may be just the beginning of more sustained USD move lower.

Before I get overly bearish on the USD/bullish on EUR, GBP and the high yielders AUD and NZD, I would note that the US dollar index’s decline matched the lows seen back at the end of April at 81.20/25. While that level holds, it’s roughly equivalent to the recent EUR/USD highs at 1.3660/80, the prospect for a dollar recovery is viable, as it would constitute a double bottom. The USD index looks set to close out the week below 81.50 and that should keep the downside pressure intact, but we need to make a daily close below that 81.20 level to get really bearish on the greenback. Also, I would mention that this past week was affected by thinner trading conditions due to the mid-week 4th of July holiday, and this may have also affected the market’s reaction to better than expected US data. In other words, lower levels of market interest were unable to overcome the downside inertia of the dollar. Next week may see a delayed reaction in favor of the USD vs. Europe, but I would still favor selling USD bounces until it clearly breaks key resistance/EUR/USD support between 1.3530/50.

Last week I also cautioned on the potential for a meltdown in the JPY carry trades (selling JPY-crosses), and while that is still my preferred view, the market seems intent on continuing to drive the JPY lower across the board. My rationale was based on two main pillars: 1) increasing risk aversion due to the sub-prime fallout in the US would lead to a reduction in the carry trades, and 2) recent indications that the Japanese ministry of finance (MOF) has concluded that the JPY should not weaken any further. Those two pillars continued to hold up during this past week, with ongoing risk reduction seeing emerging market debt sold off, and no less than embattled Japanese PM Abe chiming in on Friday NY session, just as USD/JPY was approaching the 123.50 level, that ‘Japanese officials are always watching currencies carefully.’ Most importantly the prior week’s highs in USD/JPY at 123.50/60 remained intact. We also continue to hear of Japanese corporate interest to sell USD/JPY between 123.50-124.00. Bottom line is that a day of reckoning is still to come in the carry trades, but the timing remains open. There are some important Japanese data reports due next week, along with a meeting of Eurozone finance ministers, which may provide a catalyst for a JPY rebound.

Returning to the theme of USD weakness, there may be a fair amount of confusion in the market as to why the USD should weaken, even as US yields continue to move higher and the data suggests the economy is in a sweet spot. The answer, I think, lies in the market’s perception that higher US interest rates are ultimately a negative to the debt-burdened US consumer, the main driver of the US economy. Coupled with oil prices trading at $72.50, up nearly $5 in the last ten days alone, the US consumer is facing some serious headwinds and the sustainability of current economic strength remains questionable. This view is supported by US equity markets’ inability to significantly extend gains at the end of the week even though more positive data printed. Until I see otherwise, higher US interest rates are unlikely to be USD supportive, as the longer-term outlook for the US consumer remains fragile given ongoing weakness in the housing sector, declining home prices, and rising energy costs. Finally, while US interest rates might conceivably be raised in late 2007/early 2008, higher interest rates in the Eurozone, UK, Canada and Japan are virtually assured, meaning interest rate differentials will continue to disadvantage the USD.