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“It isn’t that they can’t see the solution. It is that they can’t see the problem.”

                             G.K. Chesterton

FX Trading – US Dollar Index Failing? Follow-through would be nice …
The week was mostly shaped by China news – go figure!

As an encore to the week prior when they increased the interest rate on one-year bills and upped the required reserve ratio on banks, they ratcheted up the rate on one-year bills again. Then top officials talked about getting tougher and stopped rampant speculation before it might become a problem. Then they reported fourth-quarter GDP numbers that blew expectations out of the water.

The market responded to the 10%+ GDP number as another sign that China will keep getting tighter on lending, effectively slowing down money flow and likely dampening future readings on GDP. And when China is widely viewed as the leader of global economic recovery, investors don’t feel quite as comfortable tossing their money into “potential” growth and “greater” risk.

Thus, money has come back into the US dollar as it typically does when risk appetite ebbs.

Today, though, the dynamic is a bit different … as politics have made US markets a bit cautious.

WASHINGTON, Jan 21 (Reuters) – U.S. President Barack Obama threatened to fight Wall Street banks on Thursday with a new proposal to limit financial risk taking, sending stocks and the dollar tumbling.

Obama, a Democrat who is struggling to advance his agenda after a key election loss this week, laid out rules to restrict some banks’ most lucrative operations, which he blames for helping to cause the financial crisis.

"We should no longer allow banks to stray too far from their central mission of serving their customers," Obama told reporters, flanked by his top economic advisers and lawmakers.

"If these folks want a fight, it’s a fight I’m ready to have," he said.

So today, as risk of financial regulation is causing stocks to sell off, the dollar too is depressed. Though it’s relatively unchanged at the time of writing, it’s had to battle back from early losses.

We received a question from a Member earlier today asking:

“ … hearing a lot of grumblings that “Obama’s anti-capitalist comments yesterday will limit capital flows into the US”. Any concerns that this could change your bullish dollar view?

Our answer: no change … at least not yet. Governments can play a huge role in determining the worthiness of a country as a destination of capital. Typically, though, the more developed a country and its capital markets, the lesser the immediate and systemic impact of such “populist” or “anti-capitalist” legislation.

First we must see to what exactly this tough-talk amounts. There’s potential it’s a solid proposition that could dramatically morph the functioning of the US financial system. (The potential for unintended consequences grows with the complexity of a system; intervention only adds to the complexity of such a system.) But chances are the statement is more political jockeying than a concrete promise of drastic change, helping give Obama’s administration the appearance of siding with Main Street and against Wall Street, especially now that people are so fed up with the banker bonuses and that whole TARP mess.

Anyway, the US dollar is fighting off the sellers … battling hard to stay even on the day.

US Dollar Index Daily Chart

Today’s and this week’s finish could be huge for the dollar heading into next week. That’s because yesterday market a big-time reversal for the index after hitting 5-month highs. That breakout happens to correspond to a 61.8% Fibonacci retracement level. The dollar tried at that level back in December but to no avail.

Yesterday’s retest of this level has also failed.

Something worth noting since the bottom on this chart in November/December:

The days of dollar strength and weakness have been nearly equal in number. But the magnitudes of the moves overwhelmingly favor the bulls during the stated period of time. Is that characteristic of corrective price action, as the bulls and short-covering run their course?

We’re leaning towards no, but we’ll keep our eyes on any potential risks to our dollar view.

Have a great weekend!