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June 09, 2006

Next Week's Data to Challenge the Dollar
by Ashraf Laidi

The US trade deficit grew 2.5% to $63.4 billion in April from a revised $61.9 billion (initial $62.0 billion) in March. Exports slipped off 0.2% to $115.7 bln while imports rose 0.7% to $179.1 bln.

Despite the 8.7% rise in the unit price of oil imports, crude oil imports growth slowed to 2.2% in April from 4.4% in March. But the quantity of oil imported crude oil fell 2.8%, reflecting escalating prices. That did not stop petroleum imports from rising more than 6%, accounting for 13% of total US imports.

The bilateral trade deficit once again deteriorated with most major trading partners in April. The trade gap with China rose 9% to $17.0 bln after a 13% rise in March. The year on year rise was 15%. The bilateral trade gap with Japan edged up 3% to $7.8 bln after a 7% rise. But the trade deficit with the Eurozone fell 12% to $7.1 bln after having soared 25% in March. The trade gap with OPEC was virtually unchanged at $8.1 bln, but a 12% increase over a year ago.

Considering the softer than expected trade deficit, the dollar reaction was not too reassuring as the euro rebounded as rapidly as it dropped, before settling around the 1.2640s, well off its 4 week lows of $1.2597. Yet it does not appear that the worse is over for the single currency. As the chart shows below, there remains more ground on the downside, with 1.2550 (38% retracement of the 1.1823-1.2979 move) as the likely preliminary target for next week. With the Fed's expected June tightening looming large in favor of the dollar, 1.2550 seems plausible. But this level may prove short-lived. The explanation is below.

Will next week's US data justify further Fed tightening?

The answer to the question is a resounding "yes". The inflationary arguments for one more Fed hike are clear. With annual core PCE price index at 2.1%, the annual core CPI at 2.3% and price components of the PMIs and regional Fed surveys at multi year highs, the Fed must chase inflation as well as inflationary expectations before it is too late once it is obliged to lift its foot off the brakes to avoid a hard landing.

Nevertheless, next week's data could also show that the economic slowdown may be a little starker than it appears to be. All of the US data next week is expected to weaken. May retail sales (seen at 0.1% from 0.5%), May industrial production (seen at 0.2% from 0.8%), June Empire Manufacturing (seen at 10.9 from 12.4), June Phily Fed Index (seen at 11.0 from 14.0) and the June Univ of Michigan consumer sentiment survey (seen at 77.0 from 79.1). Even the core CPI is expected to slow to 0.2% from 0.3%. But the Fed seems to have made its case for a June tightening -- as long the core CPI does not come in below zero.

With such evident slowdown in the US economy data, the US currency has hardly anything to cheer about.

The question to be raised is: Will the Fed hike-driven optimism in the US dollar prove sufficient to hold next week, despite a predominantly weak showing in key US data.

The chart below shows the stark relationship between the US yield curve -- represented by the spread between 10 and 2 year yields and the euro/usd fx rate. The correlation is clearly positive, slowing that the lesser the yield spread, the weaker the euro, reflecting the rising dollar due to expectations of rising short-term rates relative to long term ones. But since the aforementioned data releases are hardly seen positive, we would expect the yield curve to redress and the 10-2 year spread to revert to positive territory, thereby possibly weighing on the dollar -- and stabilizing the euro.

Ashraf Laidi
Forexnews.com

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