Monday December 13, 2004 - 22:04:19 GMT
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Forex: Dollar To Rally If Fed Signals Higher Inflation Risks
DailyFX Forex Fundamentals 12-13-04
By Kathy Lien, Chief Strategist at www.dailyfx.com
· Dollar To Rally If Fed Signals Higher Inflation Risks
· Stronger US Retail Sales Fails To Bolster Dollar
· Yen Rallies On Better Than Expected Industrial Production Report
The dollar barely budged against the euro on this morning’s better than expected US retail sales report, which not only increased for the third consecutive month, but experienced an upward revision in October as well. With earlier mixed spending reports, the market was concerned that holiday shopping may not be as robust as initially anticipated. Today’s data indicates that over the past two months, consumers have stood steadfast. There are no signs of retrenchment, which provides a stronger case for a rate hike by the Federal Reserve tomorrow. However not all news was good news today. US business inventories surprised on the downside, increasing only 0.2% in October, while remaining flat in September. This could lead to a downward revision to the Q3 GDP estimate released at the end of November. Although the FOMC rate decision tomorrow holds center stage, the trade balance and industrial production reports could set the tone for the day. The trade balance is expected to widen as record oil prices in October boosted the value of imports. Meanwhile Italian industrial production fell unexpectedly. The data reflects the damaging effect of that soaring energy prices and a strong euro had on the Eurozone’s fourth largest economy during the month of October.
With little uncertainty, the Federal Reserve is expected to deliver another quarter point rate hike tomorrow, bringing the overnight rate to 2.25% from 2.00%. With third quarter GDP increasing to 3.9%, the personal income and spending gap narrowing, producer prices soaring and retail sales rebounding, the only suspense that the market can expect tomorrow will be found in the FOMC statement. Although non-farm payrolls fell short of expectations in November, the trend is still for moderate but solid employment gains. Energy prices have also fallen 26% from their peak in October, which suggests that the Fed may drop the line “despite the rise in energy prices” from the statement. The two additional wildcards lie in the inflation risk assessment and the phrase “measured pace of tightening.” With the dollar falling and producer prices increasing, it will be difficult for the Fed to leave the real Federal Funds rate (current overnight rate minus inflation rate) at a negative level. Therefore we will be watching to see if the Fed shifts its inflation risk assessment upwards. If they do, the market will begin to question whether the Fed would consider raising rates by 50bp at a time next year instead of 25bp. Although some believe that the Fed could also remove the phrase “measured pace of tightening,” we believe that it will remain, as they probably still want to leave ample flexibility to adjust policy at a pace that they are comfortable with. The Fed's intention is to bring rates back to a neutral level, or a level that does not stimulate or restrain growth and inflation, which is predicted to be between 3.5-4.0%. The only caveat is that aside from the first year after Greenspan took office in 1987, the Chairman has never presided over a rate hike in the month of December. Many believe that he has refrained from doing so in fear of being called the "Grinch of Christmas." A mere rate hike with no notable changes in the statement should have a muted affect on the currency markets. An upward revision to the inflation assessment on the other hand, could provide a boost for the dollar. However, price action in the dollar could very well be dictated by the trade balance and industrial production reports expected earlier tomorrow.
The British pound began this week on a positive note despite falling input prices for producers and a continued downtrend in house prices. Input prices basically fell in tandem with oil prices whereas output prices increased, boosting the profitability of UK producers. This trend could continue for some time since producers bore a significant amount of the higher costs this year, having only passed a marginal amount of those higher costs over to consumers since March. Although the CBI industrial trends survey improved to –4 from –16 this month, the output expectations are at their weakest levels in 18 months. 25% of the firms surveyed expect output to fall over the next 3 months, while 19% expect it to rise.
After last week’s spectacular rally, the dollar gave back some of its gains against the Japanese yen. Better than expected industrial production helped to provide a bit of optimism, although it fell for the second consecutive month. This is an extension of the recent string of disappointing economic data, which builds the case for a fall into recessionary conditions. With the recent downtrend in economic data, the Nihon Keizai Shimbun reports that the Bank of Japan could downgrade their assessment of the economy in their December economic report due for release on Friday. In the meantime, tomorrow night’s quarterly Tankan report will get all of the limelight in Japan, which is expected to fall for the first time in six quarters.
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