This week was quite active on the U.S economic front. Several key announcements gave traders insight into the fundamental factors driving the foreign exchange market. The first major event was Tuesday’s FOMC meeting on interest rates, the result of which left the target rate unchanged at 5.25%. The committee cited a substantial slowdown in the U.S housing market and a labor market near the upper end of its capacity as the two main drivers of policy decisions.
The Fed governors also commented on the proximity of inflationary indicators to the upper level of their comfort range, while reinforcing the data dependence nature of any future rate decisions. None of these announcements came as a real surprise and the result was a somewhat lackluster response in the Forex market.
The week’s second piece of economic data was Friday mornings CPI. The Consumer Price Index is one of The Fed’s more broad inflationary measures, and this months reading showed no increase from last months .1% gain. This was below the expectations of another small increase and brought down the annual rate from its 10yr high of 2.9% to 2.6%.
The stabilization of CPI is a significant development, as it shows a possible reversal of the long term uptrend in inflationary pressures. A decrease in annual CPI also suggests the U.S economy is starting to see the effects of higher nominal interest rates. As a result The Fed may have further justification to keep rates at current levels or even or slightly lower in the next 6months. It is important to keep in mind CPI is just one of many indicators, and next week there are several more pieces of data that could be major market movers.
Be on the look out for Tuesday’s PPI and Housing Starts, followed on Thursday by the Fed’s Premier inflationary indicator, Personal Consumption Expenditures (PCE). What does all of this mean? For the past few months the Forex markets have focused almost solely on the interest rate differential between the various currencies.
However, due to recent developments traders must also begin factoring in the effect of inflation and national income when forecasting the market direction. If inflationary pressures remain contained here in the U.S, and the domestic economy does in fact experience a soft landing, the dollar may have some fight in it just yet. That being said, one or two pieces of data do not make a trend, but it is definitely something to think about. Look for short term strength in the dollar to bring the major pairs to good low risk entry points.
Early in the week the Pound caught a quick bounce off support near 1.9475, but buyers were unable to sustain the move, and the pair closed the week back down at the lows. This pair is now testing 1.95 for the second time, and in the short term it is poised for further downside. If 1.9475 does not hold look for 1.9390 and 1.930 as short term support. The long term uptrend remains intact, but only a push above 1.98 will confirm a follow through for this pair.
The Euro did not fair as well as the Pound this week, as it was unable to maintain the 1.3130 support I mentioned in last week’s newsletter. The pair closed the week on support from the gap near 1.3080, but if this level does not hold look for further downside targeting 1.30 or even 1.2980 before strong support comes into play. Short term resistance is now @ 1.3190 and 1.3270.
This week the dollar fought back against the Yen and pushed all the way to 118.15. This is a perfect example of a classic the classic role reversal of support and resistance, as 118 was the level from which this move began. I am unconvinced by the recent strength in this pair though I will not try to fight the market. I am looking to fade any push towards 118.30 with a tight sell stop, and will take profits on a move towards 117.
The resistance I mentioned last week near 1.2120 broke on Friday. As a result this market rallied all the way to the next key level near 1.2230. This is a great example of why it is important to analyze the risk to reward ratio of any particular market before placing a trade. For example, last week I wanted to short near 1.2120, but only with a small position due to the lack of additional overhead support. This type of scenario shows why it is imperative to consider what will happen if you are wrong more so than what will happen if you are right. Substantial upside resistance between 1.2230 and 1.23 should slow down the current rally, though I would only consider a very small countertrend position for next week.
The Aussie was unable to hold support @ .7840 and broke out of its pennant formation to the downside. Although I believe this pair will continue higher, the short term picture remains somewhat uncertain. There is no real support down to .7775, and that increases the risk of a long trade. With that in mind, I am cautious at the current levels and would only reenter the long side at support or on a follow through above the recent highs.
For the last two months I have been patiently waiting for this market to break above 1.15 and this week it finally happened. In last weeks newsletter I suggested buying the breakout with stops below 114.70 and that worked perfectly. Be sure to protect your profits on that trade, perhaps lightening up your position a bit. If this pair continues higher and does not consolidate, look for resistance near 1.16 followed by 1.17 to take profits. In the short term I would not discount the possibility of a pullback to 1.15. Do not get greedy, keep your profits and patiently wait for a solid re-entry point. Keith Amirault December 16,2006
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