US Dollar Ends Friday on Strong Note, Could Pull Back Next Week

* Euro/US Dollar Consolidates Above Key Support - Breakout Potential?
* British Pound Outlook Hinges Upon the Bank of England's Rate Decision

US Dollar Ends Friday on Strong Note, Could Pull Back Next Week

The US dollar ended Friday mixed across the majors, as the currency gained against the euro, British pound, Swiss franc, and Japanese yen but fell versus the commodity dollars as oil rose toward $50/bbl. The greenback's gains came despite the release of disappointing US data, which also had little impact on stocks given the nearly 3 percent surge in the Dow Jones Industrial Average. This price action coincided with sell-offs in bonds and subsequent increases in Treasury yields, suggesting that interest rate expectations are in control, especially as Credit Suisse overnight index swaps are pricing in 50 basis points worth of rate increases by the Federal Reserve over the next 12 months. Focusing on the data on hand, ISM manufacturing fell to a 28-year low of 32.4 in December, signaling a sharp contraction in business activity. Even worse, the new orders and production components fell to the lowest levels since recordkeeping began in 1948, highlighting the severe impact of the US recession and global economic slowdown on manufacturers.

Looking ahead to next week, the US dollar will see a pick up in event risk. On January 6 at 10:00 ET, a gauge of conditions in US non-manufacturing sector - which accounts for approximately 70 percent of total economic activity in the country and includes retail, services, and finance – is anticipated to have worsened in December as the ISM index is estimated to fall to another record low of 37.0 from 37.3. We already know that the US economy fell into recession in December 2007, but this data will help to gauge how long the recession will drag on for. Meanwhile, the 14:00 ET release of the FOMC's meeting minutes from December 16, when they slashed rates to a record low target range of 0.0 percent - 0.25 percent, should draw some attention, especially if they highlight the Committee's plans to support the financial markets via measures that sustain the size of the Federal Reserve's balance sheet at a high level. Many have accepted this as an indication that the Fed is pursuing quantitative easing, and if it does seem that they will pursue buying longer-term Treasury securities, the US dollar could pull back as this would suggest that interest rates in the US will continue to fall. Finally, on January 9 at 8:30 ET, US non-farm payrolls (NFP's) will hit the wires and are forecasted to fall for the twelfth straight month in December at a rate of -493,000. Something that is garnering even more attention though is the rise in the unemployment rate, which is predicted to match the June 1993 high of 7.0 percent from 6.7 percent. Results in line with expectations would suggest that consumption will continue to wane through the first half of 2009, and could weigh on the greenback.

Euro/US Dollar Consolidates Above Key Support - Breakout Potential?

The euro is currently consolidating versus the US dollar within a falling wedge formation, which is typically a bullish reversal pattern, but this can only be confirmed by a break above trendline resistance at 1.3978. On the other hand, a decline below trendline and Fibonacci support at 1.3848 would signal potential for a drop toward the next region of support at 1.3575 - 1.3635. How this price action resolves may hinge upon a key indicator due to be released on January 6: CPI. At 5:00 ET, Eurostat estimates for Euro-zone CPI are projected to show that inflation growth eased to a 1.8 percent pace in December from 2.1 percent. Given European Central Bank President Jean-Claude Trichet's more bearish stance on economic growth and the bank's total of 175 basis points worth of rate cuts since October, a weaker-than-expected CPI reading could exacerbate the market's speculation that the central bank will cut rates again on January 15, and weigh on the euro. On the other hand, if CPI manages to hold at or above the ECB's 2 percent target, the currency could gain as the markets assume the central bank will not be as quick to reduce rates. It will be important to watch EUR/GBP as well as EUR/USD, as the former continues to trade near record highs. Near-term resistance for EUR/GBP looms at the December 30 high of 0.9805, but a break above there would suggest that momentum is strong enough to take the pair to parity.

British Pound Outlook Hinges Upon the Bank of England's Rate Decision

The British pound has spent most of the past month or so falling toward support at 1.4400, as the markets anticipate that the Bank of England will continue cutting rates aggressively. This could remain the case at the start of next week ahead of the BOE's next rate decision on January 8, as Bloomberg News is forecasting that the Bank of England will cut rates by 50 basis points at 7:00 ET, while Credit Suisse overnight index swaps are fully pricing in a 25 basis point reduction. This is indeed within the realm of possibilities since the UK has tipped into recession and the BOE, and UK government, anticipate that things will only get worse. In fact, the BOE's latest Credit Conditions Survey for the fourth quarter indicated that they had deteriorated, with the availability of loans down despite unexpectedly stable demand for mortgages. Furthermore, the survey said that spreads on secured lending to households and on corporate lending had widened, while defaults on household and non-financial business loans had increased. Overall, this leaves the odds in favor of year another rate cut by the BOE on January 8 and potential for EUR/GBP to target parity, but the reaction of the British pound may depend on what sort of bias is reflected in the Monetary Policy Committee's subsequent statement.