The dollar accumulated further gains on a combination of stronger than expected factory orders and latest evidence from the Fed that further rate hikes are in store. The dollar posted its biggest 3-day gain in 6 months against the euro, while tumbling an entire 4-cents against the pound, a move not seen, a slide not seen since April.

US demand for factory goods hit a 4-month high in November when it rose 1.2%, following a 0.9% revision from the previously reported 0.5% rise. Economists had expected a rise of no more than 0.9%. Meanwhile, the minutes from the Fed’s December 14 meeting showed that the members of the Federal Open Market Committee agreed on continuing to engage on a policy of gradual tightening, as part of reducing the policy of accommodation. The Fed said: “ A number of participants cited the recent depreciation of the dollar on foreign exchange markets, elevated energy costs, and the possibility of a slowing in underlying productivity growth as factors tending to boost the upside risks to their inflation outlook, though, on net, they saw the risks to stable underlying inflation as still balanced. In addition, productivity growth had slowed appreciably in the most recent quarter and unit labor costs had increased, raising questions about cost pressures going forward”.

Gold prices continued their tumble hitting an 8-week low at $423.55 per ounce in the wake of further dollar gains. The price has breached below the 50% retracement of the rise from the 395-456.75 move. Yields on the 2-year note rose 12 bps to 3.20 percent, its highest since June 2002, while 10-year yields exceed their 2-year counterpart by 1.09 percentage points, the smallest margin in over 3 years. As the yield curve flattens further, market observes could expect higher short-term rates to also reflect lower growth.

Iraq’s upcoming elections were dealt a further blow when insurgents assassinated the governor of Baghdad province and six bodyguards, while a bomb killed 10 people at an Interior Ministry commando headquarters. 5 US Five American troops also died in separate attacks. Separately, the Pentagon said the number of US troops wounded in Iraq since the start of the war in March 2003 reached 10,252, 5,396 were unable to return to duty

Euro accelerates losses

The euro’s losses have grown across the board amid a fresh dosage of strong US economic data and renewed signs of a tightening Federal Reserve. The latest minutes of the Fed showed fresh evidence that further rate hikes are in store for the next few months, thus further pushing US rates above their Eurozone counterparts. A jump in Germany’s unemployment rate to 10.8% in December from 10.4% has also weighed on sentiment.

EURUSD shattered the $1.3350 figure, which is the 38% retracement of the 1.2850-1.3664 move to stop right above the $1.3250, which is the 50% retracement of the said move. A drop below it, calls up $1.3190 and $1.3155-60—the 61.8% retracement of the said move.

Yen breaks 3-month trend line

USDJPY broke above the 104.30 trend line resistance extending from the 111.42 high thru the 106.18 high and broke above the 104.75 high. The pair sees resistance at104.5560, followed by 105.20 —the 61.8% retracemnet of the 107.28-101.80 move. This also coincides with the trend lone resistance from the 107.28 high. Support starts 103.90, followed by 103.55-60.

Sterling’s damage extend below 38%

A disappointing manufacturing PMI report from the UK showing a 53.7 reading in December from November’s 55.0 added to sterling’s gloom and added to escalation expectations that UK rates could peak at their current 4.75% level. The pair fell below the $1.8875 reading, which is 38% retracement of the 1.7750-1.19549 move and now calls up interim support at $1.8769. Key foundation follows at $1.8660—the 50% retracement of the said move. Chances for a bounce are limited at 1.8950,followed by 1.90.

At 10:00 AM US November Factory Orders (exp 0.8%, prev 0.5%) At 2:00 PM Fed Minutes from December 14 FOMC Meeting

The dollar maintained its corrective tone for the second consecutive session, as buying accelerated in the European session. The greenback pushed the sterling to 1.8929, and rose to 1.3361 against the euro. Given the previously oversold nature of the dollar, traders are attributing this recent resurgence to heavy short covering.

Today’s key economic reports will include US November factory orders and the minutes from the Fed’s December meeting. Factory orders are seen edging up to 0.8% in November, up slightly from the previous month of 0.5%. Meanwhile, the release of the minutes of the December Fed meeting should be especially useful for the market as they could give valuable indications on the extent to which FOMC officials are insistent upon further tightening. It is important to note that this would be the first time the Fed releases minutes of the most recent meeting and not of the one prior to the last.

Euro Slumps

The euro sold-off overnight amid a broad based dollar rebound, with the single currency falling sharply from just shy of the 1.35-level to slump to 1.3360. Earlier in the session, Bank of France Governor Christian Noyer downplayed the euro’s strength, saying the trade-weighted euro has not appreciated as much as the euro/dollar pair. Nevertheless, he did add that recent dollar moves were unwelcome. He also added that Asian currency pegs promote distortions, which result in risks to the global economy.

Separately, Germany’s unemployed climbed 206,900 m/m in December, lifting the jobless total to 4.46mln. The headline unemployment rate jumped to 10.8% up from 10.4% in November.

The euro remains mired beneath the 1.34-level, with support starting at 1.3360, followed by 1.3320 and 1.33. Additional losses will target 1.3275, backed by 1.3225 and 1.32. Gains will target resistance at 1.34, followed by 1.3430 and 1.3480. Subsequent ceilings are seen at 1.35, followed by 1.3550 and 1.3580.

Cable Sells-Off Sharply

Worst than expected economic data exacerbated an already weak sterling, sending cable down sharply to 1.8929. UK’s December CIPS manufacturing PMI fell by more than expected to 53.7, worst than the 54.4 forecasted and last month’s reading of 55.0. The employment index tumbled to its worst level since July 2003, dipping beneath the key 50-level to 48.7 and down from 50.9 in November.

Cable again broke through key support at the 1.90-level to tumble sharply to 1.8930. Support begins at 1.8930, followed by 1.89 and 1.8870. Further losses will be tempered at 1.8840, backed by 1.88 and 1.8770. Resistance begins at 1.8980, followed by 1.90 and 1.9060. Subsequent ceilings are eyed at 1.91, followed by 1.9130 and 1.9160.

AUDUSD Trades Narrowly

The Australian dollar remained confined to range trading, but drifted lower overnight. Support begins at 0.7720, followed by 0.77 and 0.7670. Subsequent support will emerge at 0.7640, followed by 0.76 and 0.7565. Gains will target resistance at 0.7760, backed by 0.78 and 0.7840-50. Further ceilings are eyed at 0.7880, followed by 0.79 and 0.7944 – the November high.

Dollar/Yen Revisits 104

USDJPY holds steady above the 103-level, with resistance seen at 103.60, followed by 104 and 104.20. Subsequent ceilings are eyed at 104.70, followed by 105 and 105.30. Support starts at 103.35, backed by 103 and 102.60. Additional losses will target 102.35, followed by 102 and 101.60.

The dollar rose across the board in the first trading day of the year when most European markets remained shut and Japanese markets took another week off. The dollar shed over 2.5 cents against the euro to $1.3384 since the beginning of Asian trade, but retreated over half a yen to 102.40. The dollar rally emerged well before the release of the Institute for Supply Management’s manufacturing index showed a rise to 58.6 in December from 57.8. On the bright side, the new orders index jumped to an 11—month high of 67.4 from 61.5 but the employment index dropped 5 points to 52.7, the lowest in 14 months.

SEE OUR 2005 FX FORECAST in ARTICLES & IDEAS

The dollar was able to retain its gains despite an unexpected 0.4% decline in November construction spending. That was the biggest drop in almost 2 years, following a revised 0.3% increase in October.

Gold prices tumbled more than $10 to hit a 2-month low of $426.65 per ounce in the wake of the dollar’s bounce of the past 2 sessions. The price is a few cents away from the 50% retracement of the rise from the 395-456.75 move

The dollar could gain further ground tomorrow on the release of the US factory orders expected up as much as 0.9% in November following a 0.5% rise. The release of the minutes of the December Fed meeting should be especially useful for the market as they could give valuable indications on the extent to which FOMC officials are insistent upon tightening. This would be the first time that the Fed releases minutes of the most recent meeting and not of the one prior to the last.

Euro’s sheds 2.5 cents

The euro extended its losses in European session trade as returning traders took some of last week’s gains, especially ahead of the onset of key US data. Eurozone’s manufacturing PMI rose to 51.4 in December from a 14-month low in November showing the first increase in 5 months. Today’s US ISM report dissuaded traders to stick to their dollar longs and so will the rest of the data; factory orders, ISM services, and last but not least the payroll figures. The Eurozone will also release its share of the PMI services and the CPI report.

The Bank of Spain lent further credence to the argument that European exports are little affected by the currency’s rise. Eurozone exports growth slowed to 1.2% in Q3 q/q, down from 3.1% q/q in Q2 and 1.5% in Q1. The trends were easily attributed to the moves in the euro, which strengthened in Q1, dropped back in Q2 before soaring to record highs in Q3.

Traders already talking about the February G7 meeting and what decisions will entail regarding the dollar weakness. But market players are also aware of the US ability to leave out any statements regarding the falling dollar in the last G7 meeting.

EURUSD drifts around the $1.3450s, facing support at 1.3350, the 38% retracement of the 1.2850-1.3664 move. Upside seen limited at 1.3530 and 1.3570.

Yen showing its claws

The Japanese currency rose across the board even as Japan remains shut for a week-long holiday. EURJPY was dragged to a month-low at 138.12 combining euro profit taking and yen bullishness. USDJPY exploited thin liquidity in regaining the 103.40s before shedding nearly 2 yen. Traders should watch of any signs of covert dollar buying by the Bank of Japan, which could well have been the case in the Monday Asian session.

USDJPY resistance starts at 103.20, followed by key pressure point at 103.80—the trend line resistance of the 106.20-103.43 move and the 38% retracement of the 106.20-102.30. Support starts at 102.30, followed by 101.90.

Sterling drops below $1.90

The realities of the slowing housing market seen to catch up with the pound amid rising expectations that UK rates may peak at their current 4.75% or at 5.00% at most. Tough rates are currently at their 6-year average, its unlikely the BoE will push them back up above 5.50%. Markets await tomorrow’s manufacturing PMI (CIPS) expected at 54 in December from 55, which could underline the

A drop below $1.8950, could call up $1.8875, the 38% retracement of the 1.1744-1.19549 move. Upside capped at 1.9150, followed by 1.92.

At 10:00 AM December Construction Spending (exp 0.5%, prev 0.0%) US December Manufacturing ISM (exp 58.5, prev 57.8)

With Japan, Australia, and UK markets still away on holiday, thin trading prevailed in the first session of the New Year. The major currencies were subjected to choppy trading, with the dollar rising sharply across the board initially and subsequently relinquishing those gains as the Europeans rolled in.

US economic data will return to focus amid traders in the coming week, with the key highlights consisting of December manufacturing ISM, December services ISM, November factory orders and most importantly, the December jobs report. Manufacturing ISM is seen edging up slightly to 58.5 for December, versus 57.8 in the previous month. The non-manufacturing survey however, is forecasted to slip marginally to 61.0, down from 61.3 a month earlier. Lastly, the key figure for the week will be December non-farm payrolls, in which economists are expecting a jump to 175k, up from the November reading of 112k.

Euro Whipsaws Back

Holiday-thinned trading conditions resulted in sharp swings in the euro, namely versus the dollar and yen, which tumbled to 1.3387 and 138.17 respectively early in the Asian session. Nevertheless, the single currency has since regained its composure, clawing back above the 1.35-level versus the dollar to hover near 1.3530.

Meanwhile, Eurozone December PMI beat consensus forecasts of 50.8, instead rising to 51.4 and up from November at 50.4. The new orders and output components posted gains for the first time in 5 months. However, the employment index remained bleak, remaining in contraction for the 43rd consecutive month at 48.3.

EURUSD faces resistance at 1.3580, followed by 1.36 and 1.3645. Subsequent resistance is eyed at 1.3670, backed by 1.37 and 1.3725. Losses will encounter support at 1.35, followed by 1.3480 and 1.3430. Additional declines will find subsequent floors at 1.34, backed by 1.3375 and 1.3340.

Dollar/Yen Weighed

Despite an earlier spike up to 103.45, dollar/yen was unable to sustain its gains and subsequently dipped back beneath the 103-foothold to 102.35. Support is eyed at 102.20, followed by 102 and 101.60. Additional floors are seen at 101.30, backed by 101 and 100.70. Resistance is seen at 103, backed by 103.35 and 103.60. Subsequent ceilings will emerge at 104, backed by 104.20 and 104.70.

Cable Struggles


Cable dropped from above the 1.92-level earlier in the session to briefly test session lows near 1.8985. The pair has since recovered and holds steady near 1.9080. Resistance begins at 1.91, followed by 1.9130 and 1.9155. A move higher will target 1.92, followed by 1.9240 and 1.9280. Support begins at 1.9060, followed by 1.9020 and 1.90. Subsequent floors are seen at 1.8980, backed by 1.8940 and 1.89.

Aussie Drifts Lower

The Australian dollar traded narrowly versus the greenback overnight, but extended losses to 0.7730. Support begins at 0.7725, followed by 0.77 and 0.7670. Subsequent support will emerge at 0.7640, followed by 0.76 and 0.7565. Gains will target resistance at 0.7760, backed by 0.78 and 0.7840-50. Further ceilings are eyed at 0.7880, followed by 0.79 and 0.7944 – the November high.

****TABLES & FULL FORECASTS TO APPEAR IN ARTICLES & IDEAS SECTION LATER IN THE DAY****

The deterioration of the structural imbalances in the US economy combined with the US Treasury’s policy of benign neglect for the dollar, as well as the deepening quagmire in Iraq and the resulting erosion on the budget, have all maintained negative currents against the US currency. In a trade weighted-index of 6 currencies, the dollar has fallen 32%, 18% and 5% since January 2002, January 2003 and January 2004 respectively. In 2004, the performance of the US currency was composed of 3 parts, an 11% rise between January and early May reflecting expectations of higher interest rates following improved jobs figures and increasing inflationary pressures; a 4% decline between May and end of August in a combination of increased interest rates and mounting pre-election uncertainty; and an 8% drop from September until the end of the year on record trade deficit, waning foreign flows and eroding fiscal confidence following the reelection of the Bush Administration.

The Dollar’s 5 Culprits are Here to Stay; 1) Swelling trade deficit ; 2) Widening budget imbalance; 3) Treasury weak dollar policy; 4) Waning foreign flows; 5) US real rate interest rates to remain lower than average.

1. Record Trade Deficit Matters this Time
The US trade gap continued hitting record highs in 2004, accounting for an unprecedented 5.7% of GDP. Soaring oil exacerbated the rise in oil imports, as these made up 11% of total imports in autumn 2004, twice the share in January 2002. Despite the 30% drop in the dollar’s trade-weighted value since January 2002, the US trade deficit swelled over 80%. With the US importing approximately a fifth of the world's exports, and with US imports standing over 50% greater than exports, it would take more than a falling dollar to stabilize the swelling trade gap. Since 2001, imports averaged a monthly growth rate of 0.5% compared to 0.2% for exports. Should the trend continue, the trade deficit would surpass $60 billion in June 2005. Only in the unlikely event that US exports grow twice as much as imports such as 2% exports and 1% imports, will the deficit have more realistic ways of reversing. Short of a slump in US demand that would be only brought about by a US recession, US imports show no signs of retreating any time soon, thus maintaining the negative status quo in the trade gap.

2. Why the Budget Deficit Matters
The widening budget deficit hit a record $412.55 billion in fiscal 2004 following a record $377.14 billion in fiscal 2003. The fiscal profligacy of the current US administration and its negative impact on market sentiment was largely the cause of the renewed attack on the currency after the Nov 2 election outcome. The decision to extend the first term’s income tax and dividend tax cuts has also eroded any hopes of stabilizing the fiscal imbalance. Although the President’s re-election campaign ran on the promise to cut the deficit in half by the time he leaves office, prospects remain cloudy. At 3.6% of GDP, the 2004 deficit was proportionally smaller than those of the mid-1980s, which surpassed 5% of GDP. But revenues remain doubtful when the administration struggles to contain spending. Overhauling Social Security, for example, will bear considerable costs as the administration plans to borrow as much as $2 trillion over the next 10 years to transfer a portion of workers' payroll taxes into private accounts. Meanwhile, tax revenues are at 16% of GDP, the smallest in 4 decades.

The budget deficit is important to currency markets because it raises the risk of further swelling of government and household debt via higher interest rates. The argument goes as such; when US-bound foreign capital flows are struggling to cover the trade deficit, foreign investors require a higher rate of return to hold US assets, thus, necessitating higher interest rates especially when the dollar’s value is eroded. It is these higher rates that would exacerbate the already rising personal and government debt.

3. Benign Currency Neglect
The US Treasury’s weak dollar policy of the past 2 years has also accelerated the currency’s decline despite its touting of the strong dollar being in the US interest. Two clear examples of this; 1) the US ability to exclude any statements in the last two G7 meetings urging for stabilizing dollar decline underscores the US support for the falling greenback; 2) Treasury Secretary Snow’s insistence that the dollar’s value must be “decided by the markets” at a time when markets have shed over 30% off the currency’s value in trade weighted terms since January 2002, leaves markets no choice but to infer the satisfaction of the US administration with the dollar’s trend.

4. Foreign Disinterest
The accelerating escalation of the US trade deficit relative to US-bound foreign flows has given credence to the much feared question of “sustainability”. Although net foreign inflows have comfortably covered the trade deficit in the first 10 months of 2004, standing at over $700 billion compared to $500 billion for the accumulated trade deficit, the trend has eroded significantly in the second half of the year. In the first quarter of 2004, monthly trade inflows averaged $85 billion, twice as much as the average monthly trade deficit of $46 billion. But in Q3, the monthly average of foreign flows dropped to $62 billion while the monthly trade deficit pushed up to $52 billion. The trend grew worse in October 2004 when the trade deficit surpassed foreign flows at $55.5 billion compared to $48.1 billion. In other words, in Q1, each $1.00 of the trade deficit was financed by twice as many dollars in the form of foreign flows into the US. This ratio then fell to 0.87 cents in October. Such is an ominous sign of the US’ inability to finance the swelling deficit, a trend that is clearly highlighted in the chart below. As the US trade deficit continues to grow at its current pace, it is doubtful whether foreign investors will keep up with the rate coverage especially as they require higher rate of returns on their investments to offset the tumbling value of the US currency. A shortage of the foreign financing would only endanger the slide of the dollar as investors seek instruments in other currencies.

The other disturbing trend related to external deficit financing is the over-concentration of US asset class. As of October 2004, foreign holdings of US Treasuries made up 42% of total foreign holdings of US assets, compared to 0.42% in US stocks, with the balance in corporate bonds and agency bonds. This stands in contrast with -12% in Treasuries and 38% in equities in 2000. The over-concentration of US debt instruments (treasury, agency, corporate) by foreigners relative to corporate stocks highlights the riskiness of these instruments in the face of further Fed tightening at a time when US growth shows signs of peaking but not the twin deficits.

5. Real US Rates Still Low
The Fed’s cheap money policy of the first 6 months underscored the dollar’s unattractive yields relative to the rest of the world. And even when the Fed did raise interest rates by a total of 125 bps, the real level of the fed funds rate became barely above the level of annual inflation. Yet the rate hikes failed to boost the dollar mainly due to the escalating trade deficit, whose pace of growth has outweighed the rate of foreign inflows into the US, thus raising worries about the US ability to finance its record deficit. A poll of 60 US-based economists predict the US fed funds rate to end 2005 at an average of 3.40% from its current 2.25%, and the 10-year yield at 5.10% from its current 4.30%. Such a level of fed funds rate translates at a real rate of about 2.0%, a little lower than previous estimates of 2.50%. We expect see the fed funds rate to end the year at no more than 3.25-50% and the 10-year rate to finish at 5.25-30%.

FED & ECB: DIVERGENT MONETARY POLICIES

When explaining the dollar’s drop, particularly against the euro, many overlook the impact of the divergent monetary and currency policies in the US and the Eurozone. Although the Federal Reserve has shifted towards a monetary policy of gradual tightening, i.e. taking back accommodation at a measured pace, the European Central Bank has maintained a monetary policy of relative easing, holding rates at 40-year lows since cutting them last in June 2003. The two central banks’ contrasting monetary policies have been offset by contrasting currency policies with the ECB allowing a strong euro to contain oil’s inflationary pressures and the US Treasury (and the Fed) encouraging a weak dollar. The ECB’s “tight” currency policy is mainly a result of the central bank’s explicit mandate to keep inflation at or close to 2.0%. These contrasting monetary/currency policies have largely facilitated the run-up in the EURUSD rate.

Considering these factors, it is not surprising to see why the ECB has not rushed to intervening but only resorted to talking down the euros’ rise. Yet, despite the anti-inflationary benefits of a strong euro, the ECB should start growing mindful of the impact on exports. Indeed, the average Eurozone nation derives nearly 50% of its total trade from the region, therefore is relatively shielded from the costs of foreign exchange changes. Nonetheless, slowing world growth and a soaring euro have already started to weigh on exports.
Eurozone exports growth slowed to 1.2% in Q3 q/q, down from 3.1% q/q in Q2 and 1.5% in Q1. The trends were easily attributed to the moves in the euro, which strengthened in Q1, dropped back in Q2 before soaring to record highs in Q3.
As for the question of intervention, it largely depends on the extent of the currency’s appreciation rather than solely on the absolute level of the currency. ECB officials have repeatedly echoed this message when they expressed concern with the “volatility” in the pair rather than worrying about a particular “target”. Thus, the ECB is more likely to step up verbal or operational intervention in the event that the euro hits $1.40 by next week, than if it reached it next month. When projecting likely targets of interventions, it is jut as important to consider the level as well as the time it takes for the level to be realized.

IRAQI ELECTIONS: NOT JUST A DATE

Iraq’s general elections scheduled on January 30 should bring their share of complications; both in the preceding 4 weeks and the ensuing months. Unlike the symbolic handover of power on June 30 by the Council Coalition Provisional Authority to a transitional government in Iraq whose importance largely depended on “getting it on schedule”, the January elections have much more at stake. Here is summary of the risks:

Sunni-Shia Feud to come to the fore. Although the escalating violence has been repeatedly attributed to Islamic groups and “thugs”, the “Sunni” card should not be discounted. Sunni’s minority composition in Iraq of no more than 20% of the population did not stop them from reinforcing their political majority over the past 50 years. Finally, Iraq’s 60% Shia population will finally get a wider political representation. The incoming elections are designed to produce a coalition of Shia dominated parties, making it the first Shia Muslim government in the history of the Arab world. Yet the escalating Sunni discontent isn’t about to dissipate any time soon. Iraq’s Sunni-based Association of Muslim Scholars boasting over 3,000 Sunni mosques has led the campaign to boycott the elections, calling for the elections to be postponed for six months. Thus, even in the event that the elections do take place on time and produce a Shia-led coalition, conditions will transition into a Lebanon-like protracted civil war, containing Islamic extremists, foreign fighters from Al Qaeda, loyalists to the Saddam regime/National Guard, ex-Baathists and common criminals. This would only require the replenishment of US troops at the expense of more human casualties deteriorating morale and further allocation of war spending.

Iraq’s Shia: Between Iran & the US. The Da'wa and the Supreme Council for the Islamic Revolution in Iraq (SCIRI) are the two major parties enjoying most considerable support of Iraq’s highest Shi'a religious authority. More interestingly, SCIRI and its pro-US leader Al Hakim have considerable ties to Iran—nation that is branded as the Axis of Evil. And in the backdrop of all this, Grand Ayatollah Al Sistani, Iraq’s most influential spiritual leader is carefully monitoring the political developments. Much to the dismay of many in Washington, all of this presents a disappointing loss to secular moderates. Even PM Allawi, the secular leader with much of the US fortunes and trust has not succeeded in forming a coalition slate with his own party. Thus, with key Shia figures backed by Iran and with the secularists’ role dwindling further, Washington will be at great pains of reconciling the end result with the intended objectives in Iraq.

Arab world cool to a Shia-led Iraq. A topic that is infrequently discussed is the Arab world’s reaction to Iraq’s political landscape. Baghdad’s Sunni Arab neighbors have pushed actively for Sunni participation. US allies such as Saudi Arabia and Jordan are known for their aversion to a Shia-led government, especially with a backing from Iran. Such complications could pose further problems to the balance of power in Iraq as well as to the intra-Arab stability in the Fertile Crescent (Iraq, Jordan and Syria).

Iraq’s Sunnis are not the only group calling for postponement. As many as 17 political parties have petitioned the Independent Electoral Commission of Iraq to delay the elections for at least six months. Even current Prime Minister Ayad Allawi backed such a petition.

Since the military intervention in Iraq, as many as 1,100 US soldiers have been killed and nearly 20,000 Iraqi civilians have died according to identifiable news reports. Iraq’s elections may be the turn of a new page in Iraqi politics, but could well be a new tome in a long volume of ethnic violence, nationalist reverberations and endless bloodshed.

Distracted by a change in US monetary policy, soaring oil prices, US elections and a tumbling dollar, financial markets have largely ignored the escalation of violence in Iraq. But the constant calls for boycott, the escalating human casualties and the increased assassination attempts of key political leaders will bring the Iraqi question to the fore in the first half of January, creating the following lose-lose situation for the markets; an election on schedule would not only be stained with further bloodshed but could be deemed invalid if the Sunni population went on with its boycott. On the other hand, if the election is extended to the 6 months demanded by the Sunni and rest of parties, it would be a resounding sign of failure for the transitional government.

LOOKING AHEAD

Just like in 2004, we see the dollar entering a multifaceted trend which, underlined by a decidedly negative decline largely due to continuation of the themes of 2004. With both the trade and budget deficits accounting for more than 10% of GDP, and the US Administration showing no signs of containing the currency, speculators should be encouraged to build new dollar short positions, especially that these have been cut towards year-end. Meanwhile, with very slim prospects of any upside moves in Eurozone rates, Asset managers will further test the virtues of higher yielding, capital based, currency-driven instruments such as Eurozone-bonds.

We expect intermittent bouts of dollar bounces in the first quarter resulting from profit talking by speculators and asset managers, periodic but temporary declines in oil prices and emerging signs of further tightening measures from China. We expect China’s central bank to make another rate hike in mid Q1, which would pressure commodities such as metals, thus boosting the dollar to as high as $1.3100 against the euro and 107 against the yen. But the positive dollar impact from any China tightening will eventually run its course as that would pave the way for an eventual rebalancing of the yuan into a basket system of currencies, including the euro. The dollar weak story is here to stay.

Also contributing to intermittent dollar bounces are further signs of a peak in UK rates and a moderation in tightening from the Bank of Canada. UK interest rates stand at 4.75%, exactly at their 5-year average. Given the protracted slowdown in house prices and persistently benign inflation (below target), it is unlikely UK rates will rise above 5.0%. Faced with a rising EURGBP rate, the Bank of England can afford to live with a falling dollar, especially with further rallies in EURUSD lifting the EURGBP rate, targeting the upside near 72.50 pence from the current 71 pence.

In Japan, markets are bracing for the day when inflation turns positive. Last autumn, the Bank of Japan estimated that the nation’s 9-year deflation would end in Q1. Such an event very should prove crucial in affecting interest rate expectations for the ultimate lifting of the zero interest rate policy. Such prospects would be yen bullish, especially if a tightening is not considered as a premature decision to contain an already cooling economy. Speaking of premature decisions, Tokyo’s decision to roll back as much as 1.6 trillion yen in tax cuts introduced 6 years ago is seen with cautiousness by analysts. While this is far from the 9 trillion yen in tax hikes of 1997--which sent back the nation into a prolonged recession—the possibility of fiscal and monetary tightening could generate tremendous upside for the currency, thus calling 97 yen by year end.

The Bank of Canada will also have to further raise its real interest rate from the current 0.9%, given the current core annual inflation at 1.6% and the cash rate at 2.50%. With the economy having yet to regain full capacity, and strong oil prices sustaining a durable base at the $40 per barrel zone, we see room for real rates rising towards the 1.50% level, which is equivalent with nominal rates at 3.00-3.25%. The only obstacle for any tightening is an earlier than expected rally in the CAD past the 1.17 level. Nonetheless, with smaller chances for tightening in the event that USDCAD is dragged below 1.17 before end of Q1.

We expect the dollar’s secular bear market to continue throughout 2005 due to a continuation (if not a deterioration) of the aforementioned factors. Although we expect the Fed to raise interest rates by a full point, we see the structural deficiencies of the US economy, namely the twin deficits, overwhelming the advantages of higher US yields. The latest trend of monthly foreign capital flows failing to cover the monthly deficit will require foreign investors to demand higher rates of returns from US paper, thus necessitating a stronger dollar or higher US rates. Neither the dollar could deliver that option nor could real US interest rates increase sufficiently to compensate for external concerns considering the possible peaking in US growth.

At 8:30 AM US Weekly Jobless Claims (exp 335k, prev 333k) At 10:00 AM US November Chicago PMI (exp 63.0, prev 65.2)

The dollar received further respite against the majors in overnight trading, climbing above the 104-mark versus the yen and pushing the sterling down to 1.9155. Nevertheless, euro strength continued to prevail, as the single currency attained a fresh record high against the yen and held steady near the 1.36-mark versus the dollar.

In the session ahead, traders will look at US weekly jobless claims and November Chicago PMI. Weekly jobless is seen edging up marginally to 335k, versus 333k. Meanwhile, Chicago PMI is seen slipping to 63.0 in November, down from 65.2 in October.

Euro Remains Firm

Despite the dollar advancing against the majors, the euro continues to hold firm above the 1.36-level. The single currency also reached a record high against the yen at 141.56, while continuing to assert its strength versus the sterling.

Resistance in EURUSD starts at 1.3645, followed by 1.3670 and 1.37. Subsequent ceilings are eyed at 1.3725, followed by 1.3760 and 1.38. Losses will find support at 1.36, followed by 1.3580 and 1.3520. Subsequent floors are seen at 1.35, backed by 1.3480 and 1.3430.

USDJPY Hovers Near 104

Japan’s MoF said it did not conduct intervention in the foreign exchange markets in December despite the yen’s ascent to multi-year highs against the dollar earlier in the month. Nevertheless, the Japanese government spent nearly 15 trillion yen on intervention this year, which took place in the first quarter.

USDJPY climbed above the 104-mark to reach 104.20 earlier in the session, but has subsequently relinquished some of its gains. Support begins at 103.60, followed by 103.20 and 103. Additional floors are eyed at 102.80, backed by 102.20 and 102. Meanwhile, interim resistance begins at 104, followed by 104.20 and 104.65. A move higher will target 105, followed by 105.30 and 105.75.

Cable Extends Losses

Cable remained mired near its recent lows, losing its earlier gains above the 1.92-mark to slip back to 1.9160. UK data revealed that housing prices fell in December, bringing the annual rate to its lowest level in almost 3 yrs. According to the UK’s Nationwide Building Society, the average house price fell 0.2%, compared with a 0.9% rise in November. Also released was UK’s GFK consumer confidence survey, which improved to minus 3 in December, up slightly from the minus 4 reading a month earlier.

Cable finds support at 1.9155, backed by 1.9130 and 1.91. Additional floors are seen at 1.9060, followed by 1.9020 and 1.90. Gains will target resistance at 1.9240, followed by 1.9280, and 1.93. Subsequent ceilings are seen at 1.9330, followed by 1.9370, and 1.94.

Aussie Drifts Lower

The Australian dollar traded narrowly versus the greenback overnight, but extended losses to 0.7730. Support begins at 0.7725, followed by 0.77 and 0.7670. Subsequent support will emerge at 0.7640, followed by 0.76 and 0.7565. Gains will target resistance at 0.7760, backed by 0.78 and 0.7840-50. Further ceilings are eyed at 0.7880, followed by 0.79 and 0.7944 – the November high.