After early morning weakness plunged the Dollar toward last week’s low at 74.75, shorts began covering their positions when the U.S. reported better than expected existing home sales.

The Dollar was trading sharply lower overnight and had retraced more than 50% of last week’s rally following bearish comments over the weekend by St. Louis Fed President James Bullard, who restated his case for extending the central bank’s mortgage buyback program.  Bullard said, “Unemployment is high, and labor markets are lagging.”  This comment triggered a sell-off in the Dollar because it strongly supported the Fed’s stance that interest rates would remain low for a “prolonged period.”

The EUR USD once again took a run at the psychological resistance at $1.5000 before sellers stepped in.  The rally in the Euro is being triggered by Bullard’s bearish Dollar comments and last Friday’s news that the European Central Bank would take steps to make it tougher for banks to make loans.

Traders are starting to look at the fundamentals which drive currency markets, namely the interest rate differential.  If the ECB is getting ready to exit its stimulus programs then this is a sign that interest rates will remain at 1% and possibly move higher by early next year.  This would make the Euro a more attractive investment than the Dollar because the Fed is not set to raise interest rates until at least mid-2010.

This morning’s U.S. existing home sales report came out better than expected.  This stopped the decline in the Dollar as it indicated that the economy may be stronger than previously thought. Rather than take the risk of holding large positions into tomorrow’s U.S. GDP Report, many traders used today’s housing report as an excuse to lighten up on the long side.

This friendly housing report triggered selling in the GBP USD, AUD USD and NZD USD.  At the same time the Dollar strengthened as traders lightened up short positions in the USD CAD, USD CHF and USD JPY.

Although this morning’s turnaround is not a change in trend, it is making speculators think twice about aggressively shorting the Dollar.  Technically, last week’s closing price reversal in the Dollar’s futures index is still intact, but it is going to take a rally through last week’s high to confirm that a short-term bottom has been formed.  A break through last week’s low at 74.75 will negate the reversal pattern.

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