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Strong Dollar Setting the Tone

Traders may look to GDP data this morning for direction.

The dollar is finishing January on a strong note, even though market participants are reluctant to extend its recent gains ahead of the release of fourth-quarter U.S. GDP.

The much-maligned greenback has clawed its way back from weakness at the beginning of the month and is currently trading near its best level of the month against the yen and near its best level against the old German mark since last September.

The dollar's gradual appreciation is now approaching a critical level that may prove to be a formidable barrier over the near term. The 1.7270 level against the mark and the 1.4230 level against the Swiss franc correspond to a 61.8% retracement of the dollar's slide from last summer. Many technicians view the retracement as a key measure of the market's strength. A convincing move above that level would likely trigger another wave of dollar-buying. Meanwhile, the dollar is trying to find a new trading range against the yen. Initial resistance is pegged near 117 yen, and support is seen near 115 yen.

Previously, many commentators worried that the constellation of international forces, like the slide in the Brazilian real and the downgrading of Latin American growth prospects, or the rise in Japanese yields or the advent of the euro, would undermine the dollar. Such concerns have been outweighed by the continued strength of the U.S. economy. Real sector data continue to be reported above market expectations, while price pressures are more subdued than forecasts. That favorable mix was driven home yesterday by the stronger-than-expected durable goods orders and a smaller-than-expected rise in the employment cost index.

Today could see more of the same. The median forecast calls for a 4.5% rise in fourth-quarter GDP and a 1.1% rise in the price deflator. If the market remains true to form, GDP growth is likely to come out closer to 5% and it ought not to be surprising if the deflator is below 1%. The final sales number (GDP minus inventories) is a key measure of the underlying strength of the U.S. economy. It is likely to be above 5%.

The combination of strong growth and low inflation can still be supportive of U.S. bonds.

A close above the 128 level in the March futures contract would be a very constructive sign. Some technicians are talking about a head-and-shoulders pattern unfolding with the 128 area being the neck line. If this pattern is valid, it would project toward 132, which coincides roughly with the downtrend line drawn off the October 1998 highs. The

Business Week

story that quotes unidentified


sources suggesting that the


was possibly too aggressive in cutting interest rates in the fourth quarter last year is unlikely to be much of a market factor given that Fed Chairman


indicated no such thing in his recent testimony.

Slowing growth and weak commodity prices are helping underpin most global bond markets today despite the advance in the major equity markets.

European bonds are holding most of their recent gains, which have pushed yields to record lows. Japanese government bonds continue to buck the global trend and fell today for the third consecutive session.

The yield on the benchmark Japanese bond rose more than 13 basis points to 1.995%, which is a four-week high. The ostensible trigger was news that Japanese bank regulators will prevent banks from concealing losses in the bond market by making controversial trades at nonmarket prices.

In addition, the market continues to worry about the flood of supply in the coming months. Recent auctions have not seen as much interest as past auctions. The


is looking for ways to bolster demand. According to press reports today, the LDP is considering amending a 1942 law that prevents the

Bank of Japan

from buying new government issues.

Japan did report its first decline in unemployment in five months as the January rate slipped to 4.3% from 4.4% in December. However, the data seem to reflect a growing number of discouraged workers who have given up looking for employment, which is certainly not a sign of better things to come.

Meanwhile, deflationary forces remain powerful. Tokyo consumer prices fell more than expected in January. The 0.6% decline on the month brings the year-over-rate to 0.1%.

Fears that Brazil will be forced to restructure its debt continue to weigh on sentiment.

It is, of course, in the government's interest to deny this. And it has. A restructuring of the domestic debt would be a major blow and would add insult on top of the injury of the plummeting currency.

At this juncture, a restructuring of the government's debt is not a foregone conclusion. However, the failure of yesterday's auction does little to engender hope or confidence. Yesterday, the government rejected bids in its auction of 800 million reals paper (of which 300 million was dollar-indexed). Last week, the government sold 29-month paper for 18.99%. This week it rejected offers nearly twice as high. The government hopes to entice more foreign investors by reducing the minimum maturities of foreign borrowings from a year to 90 days and by reducing the minimum period for rolling over foreign loans to 90 days from 180 days. These measures are going do painfully little in attracting fresh foreign investment while the currency plummets and interest rates are hiked.

Lastly, note that Brazilian President


received support from the

World Bank

, which suspended credit to the couple of Brazilian states that are refusing to service their debt to the federal government on grounds that they have lost the government's guarantee.

Marc Chandler is an independent currency strategist whose column appears Mondays, Wednesdays and Fridays.