Unhappy New Year for the Greenback

The dollar falls hard for a second day amid concern about the Fed's plans and economic vigor.
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The new year hasn't started well for dollar bulls.

Over the first two trading sessions of 2006, the greenback saw its biggest decline against the euro in over four years.

In recent action Wednesday, the euro was up 0.9% at $1.2128, after gaining 1.7% on Tuesday. The dollar also fell vs. the yen, recently trading at 115.92 from 116.17 yen on Tuesday.

It must be said, almost all of the factors that can undermine the dollar were gathered on Tuesday: weak economic data, the confirmation of the

Federal Reserve's

new dovish inclination, and another step from China toward revaluing the yuan.

Starting the dollar's decline, the Institute for Supply Management's manufacturing survey for December came in well below expectations and showed a marked decline in the prices paid by manufacturers.

The data were followed by a sharp drop in the dollar in morning trade, even before the Fed released the minutes of its Dec. 13 meeting on Tuesday afternoon.

"The ISM was not a disaster," notes Ashraf Laidi, currency strategist at MG Financial Group. "But the

dollar move was so sharp in reaction that it shows the market is now scrutinizing U.S. economic data very closely."

Given that inflation still remains slightly above the Fed's comfort zone of between 1% and 2% and the Fed said on Dec. 13 monetary policy was no longer accommodative, economic data are now taking center stage. Looking ahead, Thursday's non-manufacturing ISM survey and Friday's December employment report will very be closely monitored by currency traders.

Dollar losses accelerated Tuesday as the Fed's minutes were released at 2 p.m. EST. In the minutes, a majority of Fed members said they expected "the number of additional firming steps required probably would not be large," although economic data would continue to dictate policy.

Another blow came when the People's Bank of China (PBOC) reset the exchange rate between the dollar and the yuan at 8.0702, representing another 2.5% revaluation of the Chinese currency from its pre-revaluation rate of 8.28. Also on Tuesday, over-the-counter trading of the yuan officially began.

Weakness continued on Wednesday, after reports of an earthquake some 50 miles off the coast of California first sparked concerns that a tsunami may occur. Such concerns faded quickly after the Pacific Tsunami Center said there was no threat.

Still, the reaction of currency markets over the past two days seems to confirm Laidi's view that "the market's stance is positioned towards further dollar weakness."

That's not very surprising, given that most economists and currency strategists expect the dollar to weaken this year once it loses the support it received from the Fed's sustained monetary tightening of the past 18 months. Once the Fed does stop raising rates, structural issues such as the U.S. current account deficit are seen weighing on the greenback.

But there's reason to believe that dollar weakness over the past two sessions is not necessarily the beginning of that bigger trend.

According to IdeaGlobal currency strategist David Powell, the market had been "starved" of significant economic data -- and of liquidity -- in the last couple of weeks of December, and it seized on Tuesday's deluge of news to shake out long dollar positions.

But the euro, he noted, has not broken out of the $1.16 to $1.22 range it has been in since May of 2005.

"This is not the beginning of a new trend," Powell says. "We knew what the Fed's position had been since Dec. 13," and now the market will take its cues from the data.

For the time being, the dollar still remains supported by attractive yield differentials between U.S. rates at 4.25%, compared with the Europe Union's 2.25%, and Japan's at 0%.

And there's a chance that the dollar may surprise on the upside in the first quarter, should economic data and inflation come in stronger than expected, Powell says.

For the greenback, everything will indeed depend on whether, or rather how much, the U.S. economy will slow. The yields of short-term bonds surpassed of the yields of long-term bonds several times last week, signaling to some that there's economic trouble down the road.

In recent action, the yield of the two-year note stood at 4.31%, while that of a 10-year bond was at 4.36%.

The stock market, meanwhile, remained in positive territory Wednesday after rallying sharply following the Fed's minutes on Tuesday. Gains were led by the technology sector after Bear Stearns upgraded

Google

(GOOG) - Get Report

, which was recently up 1.4%.

The

Nasdaq Composite

was recently gaining 0.81% to 2261.98. The

Dow Jones Industrial Average

was up 12.57 points, or 0.12%, at 10,859.98, and the

S&P 500

was up 3.77 points, or 0.3%, at 1272.57.

In keeping with TSC's editorial policy, Godt doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He appreciates your feedback;

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