Economy Stronger, US Dollar Weaker—What Gives?

02/02/2011 5:01 am EST

Focus: FOREX

Greg Michalowski

Chief Currency Analyst, FXDD

The ISM (manufacturing) report was stronger than the previous month. General Motors (GM) sales were much stronger. Construction spending was weaker, but housing has been a pleasant surprise of late with existing and new home sales both improving last month. Overall, the data in the US has been better. So why is the dollar so weak?

The difference is that the Fed seems content to ignore the inflation. The other countries are expressing fears of inflation working it’s way into the overall prices. This Thursday, the European Central Bank (ECB) announces their interest rate decision, and although the ECB is expected to keep rates unchanged, (ECB President) Jean Claude Trichet is likely to continue to speak of inflation risks.  Yesterday, the Bank of England’s Weale was extremely hawkish with his comments about inflation.

As a result, currencies like the euro and pound benefit at the expense of the dollar. The weaker dollar can increase export growth, and perhaps lead to stronger jobs and a stronger economy in the US, but it should also lead to higher interest rates and inflation that does not disappear. Global investors may begin to shun debt auctions and further increase interest rates, which could have the effect of stunting growth—not enhancing it.

Bernanke and the Fed in their comments after the last interest rate decision spoke about the commodity price rise, saying “Although commodity prices have risen…”—they followed that up with a largely ambivalent assessment on inflation—”longer-term inflation expectations have remained stable, and measures of underlying inflation have been trending downward.”

Clearly, central bankers on either side of the Atlantic have differing opinions and the dollar is reacting accordingly.

Of course, the forex market has its ups and downs. However, on January 21, the price of the EUR/USD moved above the 100-day moving average (MA) and the 50% retracement of the November-to-January fall and has not been below since.

The GBP/USD tested the 100-day MA on the day of the -0.5% surprise GDP but moved above its 50% retracement level the next day and has been above both since. If the technicals remain bullish, the price can continue its march higher and in the process leave the Fed and the dollar behind to fight the inflation fight later.

It’s clear that forex traders need to watch the charts more closely than ever. Fundamental news and how the US dollar has reacted in the past appears to be less helpful in determining how it will react in the future.

By Greg Michalowski of FXDD.com

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