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Today's commentary is by Sean Hyman, our Currency Director and editor of The Money Trader.

Good Day Currency Traders!

Yesterday, two European Central Bank officials let their real views slip about Eurozone inflation. In short, they're concerned - and they're ready to take action to fight inflation.

In response, the euro rallied against both the U.S. dollar and the Japanese yen.

That's not surprising considering ECB President Trichet just gave his own hawkish statements last week - as I mentioned in Friday's My Two Cents.

It appears that the Eurozone boys are ready and willing to hike rates if inflation continues to raise its ugly head. In fact, ECB official (and governor of the Bank of Finland) Liikanen, stated that he sees "increasing upside risks to inflation."

ECB official, Stark, also said he didn't agree with the ECB staff forecasts that inflation would slow to below 2% in 2009.

Some economists are also feeling that the EUR/USD exchange rate could be supported if the U.S. cuts rates and the ECB stays on hold or raises rates. Either case could be bullish for the EUR/USD.

Many investors are leaning towards an upward bias for the EUR/USD in the near-term. I have to agree. It wouldn't surprise me to see the EUR/USD hit the 1.4900 to 1.5000 level in the upcoming days or weeks.

The ECB Walks the Tight Rope
However, the ECB is stuck between a rock and a hard place. They have to fight inflation on one hand. They can't afford to be lax about that. Fighting inflation means hiking interest rates. Hiking interest rates means that money will be drawn to your currency which pushes the euro up even higher. That leads to higher EUR/USD and EUR/JPY exchange rates. The current sky-high exchange rates are already hurting France's exports. It won't be long before it spreads to the remainder of the Eurozone.

So the ECB really has a balancing act. I'm glad I'm not in their shoes because it won't be an easy decision. They may have to sacrifice their export sector in the near-term to fend off inflation for the long-term good of the economy as a whole.

I wouldn't want to be a European exporter right now with such a high exchange rate on EUR/USD and EUR/JPY. The high exchange rates make their exports more expensive to those wanting to import them.


Euro Wins the Arm Wrestling Contest over the Dollar


Note that the EUR/USD just closed above its near term downtrend line for the first time in over two weeks. This is the first sign of life that it's had since then.

In the chart below, you'll see the euro won a recent battle against the yen's ceiling of resistance that has lasted over a week and a half now.


Carry-Trade Demand Comes Back for EUR/JPY


These high exchange rates could crush the manufacturing sector. If it does, it could eventually be a catalyst to help slow inflation. If that happens, that could encourage the exchange rate downward.

Here on the other side of the pond, the U.S. has already cut interest rates. It's anticipated that there will be more to come. This is where it gets ugly for the Eurozone because even when Europe starts cutting rates, the U.S. is already way ahead of them in the rate cutting game.

As rates get cut, money tends to flow away from a country's currency. However, if it flows away from the U.S. quicker than it does the Eurozone, then it will hold the exchange rate a little too high for the ECB's comfort.
The Euro Will Eventually Fall
Despite the Weak U.S. Economy
So while these are some valid scenarios of what could happen, I believe that the dollar will get a bounce once the euro takes a stab at 1.49 to 1.50. Here's why...

The last time that the euro tumbled from 1.36 down to 1.18, the U.S. economy wasn't rocking and rolling then. Yet the dollar rallied against the euro anyway. So the euro exchange rate could eventually fall even with the shaky financial situation here in the United States.

The EUR/USD pendulum has almost swung to a far extreme again. When it reaches that point, it won't matter if the U.S. markets are still being battered. The exchange rate will take a dive and finally give Europe some relief, and support to the U.S. dollar.

Sean Hyman, Currency Director





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Making 'Cents' of the Headlines
The Wings of the Dove vs. the Bite of a Hawk In the Currency Markets

If you watch the currency markets, you'll eventually hear traders talk about a Central Banker acting "dovish" or "hawkish."

So what's the difference?

A hawk is known to be an aggressive predator that keeps a sharp eye out for potential prey. In a similar fashion, a "hawkish" central banker keeps a sharp eye on interest rates because they're ready to swoop in and aggressively raise rates to fight inflation if necessary.

The dove has a harmless, docile nature. Therefore if you hear a central banker referred to as "dovish" or called an "inflation dove," then he's not concerned with inflation. He would rather lower interest rates because he feels inflation will have a minimal effect on society.

So these terms don't describe the central bankers' long-term stance on inflation, but just their current short-term views. These are likely to change over the course of their tenure.

During any Fed chairman's tenure, he's likely to raise interest rates and then lower them depending on the economy's situation at the time. So the present view of the central bank is termed "hawkish" or "dovish."

For example, as we said above, ECB President Trichet is extremely hawkish, while Bernanke has had dovish views for months now.

Tip: When you run across a currency term that you don't understand, put it into the search field of www.fxwords.com or www.investopedia.com . I find these sites to be very helpful.