A fourth consecutive down day for the US dollar (on a trade weighted basis) defines the worst trend the benchmark has suffered since September. The currency’s bearish bearings have been set for going on four weeks now; but through this unfavorable drift, there has been a clear lack of conviction – often termed momentum. Without a decisive trend in underlying sentiment or a clear shift in Fed interest rate expectations, it seems the greenback is anchored to well-tracked ranges.
- US Dollar Extends its Worst Trend in Four Months after Retail Sales Drop
- Euro: ECB Casts a Dovish Forecast, Warns Market about Greece’s Influence on Region
- Australian Dollar Rallies as Employment Data Fortifies Rate Expectations

US Dollar Extends its Worst Trend in Four Months after Retail Sales Contracts
A fourth consecutive down day for the US dollar (on a trade weighted basis) defines the worst trend the benchmark has suffered since September. The currency’s bearish bearings have been set for going on four weeks now; but through this unfavorable drift, there has been a clear lack of conviction – often termed momentum. Without a decisive trend in underlying sentiment or a clear shift in Fed interest rate expectations, it seems the greenback is anchored to well-tracked ranges. The best representation of the underlying dollar’s lack of strength and volatility is best reflected with EURUSD. A modest gradient on a very consistent, rising trend channel has contained price action but not with highly precise levels of support and resistance. Though heading into the final trading day of the week, there are more reliable short-term levels to watch such as 1.4450 as a floor and a 1.4560-ceiling. Both the yen and Swiss franc-based majors offer similar patterns; but it is the commodity bloc that highlights the importance of risk appetite among FX traders. With an exaggerated yield differential heightening its appeal, AUDUSD is just below a 14-month high. And, whether it holds water or not, both the NZDUSD and USDCAD have ridden the Aussie’s coattails to meaningful levels of dollar-support as well.

With this eerily-quiet backdrop in mind, we must remember that most fundamental drivers for the US dollar at this point are filtered through speculation surrounding either underlying investor sentiment or the currency’s position on the risk spectrum. This is largely why some historically market-moving indicators have fallen flat with volatility while seemingly innocuous news can set things in motion. Today’s data would be good for only a modest adjustment to the health of the US economy and market-wide risk appetite. The top release was the December retail sales report from the Census Bureau. Against an official consensus forecast of a minor increase in consumer spending, the report showed a 0.3 percent contraction. No matter how the data was sliced (looking at individual sectors, cutting out vehicle sales or gas), the data was moderately dovish. However, there are arguments that this data could have been distorted by seasonal adjustments or due to the blizzard that struck the Northeastern United States. What’s more, sentiment was modestly improved by a revision to November’s readings (upgraded to a 1.8 percent increase from 1.3 percent). Regardless, this data maintains, the recovery for the US will be uneven and tepid as the economy works through high unemployment, stunted lending, low business investment and many other factors.

In the bigger scheme of things, a stable economic footing is essential for the eventual return of hawkish monetary policy. However, policy officials do not have the luxury to simply wait for the recovery to fully setup and all other factors to fall in place. Should inflation return with force, the Fed could be pushed into a tightening regime to prevent a much more complicated economic scenario from unfolding. The Import Price Index released today showed no monthly change in imported inflation; but the annual rate accelerated to a 16-month high 8.6 percent. To truly unnerve the central bank through, Chairman Ben Bernanke and his fellow board members have to see a distinct threat of medium-term consumer price pressures holding above the their target. The consensus for Friday’s December CPI reading already puts the reading above the 2.0 percent objective with a forecast for a 2.8 percent annual reading. A reading this high or greater (especially should it be backed by a big increase in the annualized core figure) will certainly weigh on rate speculation. But will it be pressing enough to unsettle the dollar?

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Fundamental Outlook for US Dollar: Bullish

- Dollar enjoys safe haven status, loses interest rate potential
- Has the dollar’s late-week correction altered the bullish revival?

Dollar bulls seem to enjoy a bit of schadenfreude. While the financial markets are under strain and the risk of a full blown crisis is at its peak, the benchmark currency shines for its safe haven properties. Without this background preoccupation, the greenback seems relatively lackluster compared to its primary counterparts. With a benchmark lending rate just above zero, a growth forecast that calls for a significant cooling of pace in the second half of this year, an overwhelming debt load and the nagging concern that the world may one day trade out their dollars for some other reserve currency; the currency will struggle to compete on an even playing field. However, markets are dynamic and speculative interest is an indelible component of its normal functioning. For this reason, the basic assumptions of relative growth and yield are only impressive or disappointing so far as investors are excessively greedy or risk adverse. Considering the fundamental waves that are seen over the coming week, this particular angle promises to define the dollar’s next move.
At the very forefront of the fundamental trader’s mind is what will happen over the weekend. Concerns over Greece contributed to the greenbacks gains last week and it also set the benchmark to its sharp correction. Therefore, it is reasonable to believe the same source of activity will maintain its continue to define volatility ” at least through the near-term future. This event is at the brink of another critical stage. No longer is there doubt that the nation is in trouble. Now, they are holding out their hats and asking for assistance. What does this mean to the dollar trader? If confidence or the EU fails Greece, this country will very likely default, exit the monetary union or find some other unique and painful solution. This will almost certainly hurt the euro in the eyes of investors; which will send capital fleeing to its primary counterpart (the US dollar). Wading deeper into this scenario, if Greece falters; it would likely send credit and financial market ripples across the world. Considering the current, over-extended level of most growth-related assets, such a catalyst could have dramatic consequences. That being the case, the traditional harbor for rough seas ” the greenback ” will open to all.

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Summary (Euro Outlook: Neutral)
- Events: Tues-German, Euro-zone, ZEW Sentiment, Wed-German PPI m/m, y/y, Thurs-ECB Monthly Bulletin, Flash Manufacturing and Services PMIs for the Euro-zone, France, Germany
- The ECB’s tough choice: remain on target for stimulus exit and rate increases later this year and boost the euro, but a strong euro would do to the weaker economies exports
- EZ ongoing Greek tragedy could spread well beyond its national borders, Spain & others could be worse still, plenty of other fiscal problem children, so ECB must make an example of Greece
- German Economic Minister Bruederle talks down euro sentiment, saying that Germany was not experiencing a self-sustaining economic recovery
- Economic data further undermined euro this past week
- EURUSD maintains its ascending channel for now despite the above travails

Analysis
While the EURUSD can be a misleading gauge of strength for the euro (as it has recently been more responsive to the US dollar), the benchmark pair currently presents an accurate portrayal of the single currency, its main uptrend long broken by dollar strength, now struggling to hold onto another such rising channel.

Key Euro Drivers
Taking a quick glance across the majors, it becomes apparent that nearly every one of the euro crosses is sitting at the bottom of a broad range. It is make or break time for the unloved currency; and the catalyst for its ultimate bearing will likely fall to one of four pressing issues:
1. The financial stability of the European Community (particularly of the PIGS: Portugal, Greece, Ireland/Italy, Spain), referred to often in these pages as sovereign debt threat
2. US dollar performance either improved fundamentals or
3. US dollar performance as a safe haven should risk appetite retreat
4. A meaningful change in interest rate forecasts

The US Dollar
The primary driver of the euro is the interplay of risk appetite and the dollar, points 2 and 3. Because the EUR/USD pair by itself is about 30% of all forex trade, these two currencies tend to push each other in opposite directions. Should risk appetite rally or plummet, expect EURUSD to follow suit. See our US Dollar Weekly Outlook for the key events and forces to watch for measuring the dollar’s outlook, and thus so too the euro’s.

Sovereign Debt Threat
The next major concern is the threat of further sovereign debt downgrade or outright default. This has loomed large over the euro since Dubai World’s problems drew attention to sovereign credit risk and got the various rating agencies attention and alerted them not to be caught unawares again.?? The failing financial health of Greece, which clearly has lacked the political will for real financial reform, has undermined confidence in the euro and in prospects for the growth, stimulus reduction, and rate increases needed to support the euro.

The downside of developing a single market among different nations has been laid bare through the recent economic difficulties. In sum, fundamentally different economies have different needs and priorities While German and France have been quick to recover and can benefit from a stronger euro as the group’s most prosperous members, others have struggled to recover, particularly as a strengthening euro hits their more easily replaceable, less competitive exports, harder.

Most crucially, each member government gives up lot of flexibility to combat financial downturns, like its right to individually adjust monetary policy, manipulate its currency, increase its debt load and more, that have given the US, UK, and others crucial tools to adapt to unfavorable conditions. It is unclear how many of the weaker members will meet the goals policy makers have set out and EU officials have warned no exceptions will be made. Currently the balance of power in setting policy is clearly with the wealthier Northern countries.

The current picture offers no clear solution. The Greek PM reiterated that Greece was not seeking any IMF bailout or planning to exit the Euro Zone, but then again he provided practically no details on how the country would finance its budget or drastically cut its debt-to-GDP ratio in order to meet the EU’s Maastrict criteria. The ECB published its opinion on Greek debt restructuring law, stating that the move could hinder the flow of credit and hurt markets. On Friday, the ECB’s Trichet talked tough, declaring that the country has a “major debt problem” and that no government should expect special treatment,” specifically mentioning both the Greek and Irish situations. His words pushed the 10-year Greek/Bund spread beyond the 280bps level. Spreads among other peripheral European debt have widened noticeably as well: the Ireland/Bund 10-year spread was at +162bps, while the Portugal spread was at over +95 bps, at its widest level since last April. In short, it’s getting more expensive for these countries to borrow, creating a vicious downward spiral.

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In fulfilling its role as the primary counterpart to the US dollar, the euro is naturally imbued with the traits of a high-yield currency (at least when it comes to EURUSD). While the European benchmark lending rate is anemic in its own right and growth forecasts are perhaps more reserved than its US counterpart; diversification away from the greenback naturally channels capital into the next most liquid currency in the FX market. This is a particularly meaningful relationship considering the desire by many of the world’s policy authorities to reduce reserve, domestic monetary policy and economic activity to the health of the whiles of the US dollar.

On the other hand, when risk aversion rises; the euro is often the standard bearer for the flight to safety that sends the greenback rallying. We are currently at the cusp of a dramatic shift in underlying sentiment. For much of this year (from Approximately February up until the start of December), sentiment has steadily advanced as investors have put their capital back into the speculative market space. However, the advance that has resulted has moved well beyond the realistic expectations of growth and expected yield growth. Eventually one has to correct to the other; and fundamental economics measure changes in months and quarters. Yet, when positioning for such a significant shift; it is important to confirm that such a seismic change is underway. If a EURUSD break is indeed underway; equities, commodities, fixed income and most other risk-attuned asset classes will all fall into line.

Moving beyond the gravitational pull of the US dollar, the euro is making significant headway on its own. Among the medium-term trends to keep track of for the euro is the slow shift in monetary policy and the pace of the region’s recovery as compared to its peers. The European Central Bank held its benchmark lending rate unchanged at its December 3rd meeting; but the event nonetheless developed a hawkish bias when President Jean-Claude Trichet said unlimited 12 month loans would expire this month and 6-month loans at the end of the first quarter. Officials have said that this should not be considered a sign that the bank is preparing to raise rates; but this is an inevitability given the path the bank is now on. As for growth, there Euro Zone is the collection of member economy’s that are recovering relatively quickly and those that are struggling. The Bundesbank raised its outlook for growth in Germany from stagnant to 1.6 percent in 2010. In contrast, EU ministers are very concerned about the state of Greece’s burgeoning deficits. If the laggards of the region are not supported; it could keep the entire Euro Zone from a robust recovery.

Fundamental Forecast for Euro: Bearish
- The ECB holds rates but takes to the hawkish path by slowly removing stimulus
- Advanced Euro Zone consumer inflation reading turns positive for the first time in seven months
- EURUSD on the verge of a reversal of this year’s trend. Will the dollar take the plunge?

The economic docket for the euro may look somewhat reserved over the coming week; but this should not subdue traders into passivity. In fact, the currency may be spurred to dramatic-levels of volatility should the dollar rally or underlying fundamental themes develop. The pressure on the single currency is most poignantly reflected in EURUSD’s standing. This single pair is the most liquid in the currency market and is therefore the benchmark for trends in not just the euro; but for the entire financial market. Through the end of last week, the pair marked a dramatic correction in the span of only a few hours when it plunged from a range and trend-high just below 1.5150 to support that defines a nine-month advancing channel. Arguments can be drawn that the actual trend that represents the backbone of this steady ascent has already been broken; but true confirmation will come from a meaningful push below 1.4800. However, a simple technical break on a single pair cannot define a pervasive trend on its own. To see a true changing of the guard with EURUSD, we will need to see a definitive reversal in underlying risk appetite.

Shades of the roiling energy markets that were set off last year by the crisis on Wall Street emerged again Friday with crude seeing the largest percentage drop in prices since January.

The sell-off this time followed troubling news from Dubai, which asked lenders for a six-month reprieve on payments for about $60 billion in debt.

Benchmark crude prices plunged by 7 percent in early trading, though those declines eased as investors weighed the chances that Dubai’s problems would spread to Europe, Asia and the United States.

It was the fear of frozen credit markets last year that sent crude prices from $147 per barrel in July to about $32 by December.

Crude prices bounced off six-week lows Friday as investors digested the news. The New York Mercantile Exchange, where U.S. benchmark crude is traded, was closed Thursday for a holiday as information from Dubai emerged, which could have exacerbated the selling.

Benchmark crude for January delivery fell $2.20 to $75.76 on Nymex by midday Friday.

At one point, prices had dropped $5.57, the largest dollar decline since April 20 when crude prices tumbled $4.45 to $45.88.

Any decline in the price of crude would likely help most consumers in the short term because gasoline and other fuel prices tend to follow the direction of oil.

Dubai has experienced unprecedented growth over the past decade, and the semiautonomous city-state has spent billions on sprawling man-made islands, an indoor ski slope and the world’s largest tower.

It’s main funding vehicle, Dubai World, said it would ask creditors for a “standstill” on paying back its $60 billion debt until at least May.

That helped send the U.S. dollar higher, which can add more downward pressure on oil prices.

Crude is bought and sold largely in dollars, so investors holding major currencies would have to pay more to buy oil when the dollar rises.

“The strengthening dollar is dislodging a huge amount of speculative capital,” said Jim Ritterbusch, president of energy consultancy Ritterbusch and Associates., adding that energy demand weakness throws yet another wrench into the industry’s recovery.

In other Nymex trading, heating oil fell 3 cents, or 3.1 percent to $1.9599 a gallon. Gasoline for December delivery dropped 5.46 cents to $1.943 a gallon. Natural gas for January delivery climbed less than a penny to $5.17 per 1,000 cubic feet.

In London, Brent crude for January delivery rose 6 cents to $75.05 on the ICE Futures exchange.

Trading began on a positive note this week, as indices pushed out to a fresh 13-month highs despite the slide in the November Empire Manufacturing data on Monday. Equity indices were flat mid week as October housing starts declined to their lowest level since April, and building permits came in to the downside and corporate news remained fairly light. On Wednesday the Baltic Dry Index rose to its highest levels since last September, another milestone of the Asian recovery. But things fell apart on Thursday as equity weakness in Asia on concerns of a growing asset bubble carried through into European and US trading, firmly knocking US equities off their highs. Light volume and the weekly jobless claims data were a contributing factor, as the data came in very modestly higher. Bleak earnings from Dell and USD strength kept equities weak into the close on Friday. For the week, the Nasdaq composite led the way down, weighed on by a note from Merrill downgrading the tech sector, including such heavyweights as Intel and Microsoft: the Nasdaq dropped 1.0%, the S&P 500 declined 0.2%, while the DJIA eked out a 0.4% gain,

The week commenced with markets squarely focused on the first official remarks from Fed Chairman Bernanke since the FOMC meeting two weeks ago. The advanced text of his speech to the NY economics club appeared heavy on strong US dollar rhetoric, providing some hope for the weary greenback. This rhetoric was quickly dismissed as it became clear that a continued low inflation outlook coupled with a dismal employment picture will force the Fed to keep rates low for an extended period of time. In the Q&A session, the Chairman acknowledged that the Fed needs to deal with the possibility of developing asset bubbles, but noted he has yet to see any “large misalignments” in US valuations. The weaker-than-expected US Producer Price Index and Industrial Production data only confirmed Bernanke’s comment that significant challenges still face the US economy and prompted many to speculate that the FOMC’s long period of low borrowing costs might get even longer. As PIMCO’s Bill Gross wrote in his monthly outlook this week, the US needs another 12 months of 4-5% nominal GDP growth before the Fed dares exiting the “0% foxhole, mini-bubbles or not.”

Many participants took Bernanke’s comments to mean the door will remain open to the notion of the US Dollar as a funding currency and the accompanying expansion of risk appetite. The Fed’s Yellen only added strength to this argument (and raised some eyebrows) when she said on Wednesday that the US stock market is not overvalued and credit spreads do not reflect a bubble. In addition, the Fed’s Bullard gave markets a history lesson, warning that the FOMC did not begin rate increases until two to three years after the end of each of the past two recessions. The comment was misinterpreted and immediately sparked rumors that Bullard had said the Fed would be “on hold” until 2012, providing bearish dollar momentum and boosting spot gold to yet another all-time high.

Financial names helped push overall equity markets lower this week, especially after another serving of doom and gloom from Meredith Whitney. On Monday she said “I have not been this bearish on financials in a year” and reiterated that banks will need to raise more capital. The press speculated that the administration would extend TARP through 2010 (last week it was reported that TARP has $239B in unspent funding). On the positive side, October credit card master trust data showed that on the whole net charge offs declined sequentially for a second month in a row, offering more evidence that the business is stabilizing. The October advanced retail sales data jumped dramatically, to a 1.5% gain versus a 1.5% decline in September, although many commentators pointed out that the data owes most of its big gain to auto sales. Continuing discussions of a Tobin Tax on financial transactions lurked in the background in both the US and Europe.

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Annual inflation in Saudi Arabia fell to 3.5 percent in October from 4.4 percent in September, official data showed Sunday.

The Kingdom’s cost of living index was 124.3 points in October up from 120.1 points a year earlier, the data published by the official statistics authority showed.

“Although inflation has come down on an absolute basis, month-on-month it still remains high and it could very well average above 5 percent for the year,” said John Sfakianakis, chief economist at Banque Saudi Fransi.

“A slight increase in food prices and high rental costs, as well as dollar weakness, will contribute to inflation remaining historically high.”

The Saudi central bank said earlier this month it kept interest rates unchanged in the third quarter, viewing a further rate cut as unlikely to spur lending while a rate hike was unnecessary given tepid inflation. The Saudi Arabian Monetary Agency (SAMA) held its main rate at 2 percent in the third quarter because of declining inflation and a need to support lending in a banking sector hit by debt restructuring concerns in family firms.

It has slashed its benchmark lending rate by 350 basis points since October 2008 as an oil price collapse sent the top Arab economy into a downturn and inflation fell from record highs.

Analysts have said the Saudi easing cycle was probably over for now and the central bank also needs to watch for potential signs of inflationary pressures after consumer prices rose for the first time in four months in September.

Saudi Arabia, like its Gulf Arab neighbors, pegs its currency to the US dollar. Kuwait dropped the link in 2007, opting for a peg to a currency basket.