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Tuesday December 14, 2004 - 22:24:49 GMT -

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Forex: Dollar Fails To Budge On Wider Deficit And Rate Hike

DailyFX Forex Fundamentals 12-14-04

By Kathy Lien, Chief Strategist of

· Dollar Fails To Budge On Wider Deficit And Rate Hike
· Fed Raises Rates By Quarter Point to 2.25%
· Pound Rises On Higher Inflation

As we run down our checklist of US economic data released so far this week, we continue to be disappointed by the lack of reaction in the currency markets to both better than and worse than expected data. The dollar barely budged on Monday’s stronger retail sales report and this morning’s wider than expected US trade deficit. The Fed’s much-anticipated quarter point rate hike also resulted in a muted reaction in the currency markets. It seems as if people are already beginning to close their books ahead of the Christmas and New Years holiday. However we caution against becoming too complacent as tomorrow’s Treasury International Capital flow data still has the potential to alter the near term outlook for the greenback. With the dollar driven lower by concerns about the current account deficit, the TIC data will be one of the most anticipated reports next week. A large and growing current account deficit in the US requires net foreign capital inflows on the order of at least $1.8 billion per day. The TIC report acts as an approximate gauge of foreign investor willingness to finance this deficit. Smaller than expected net foreign purchases offer a possible signal that the deficit may be becoming unsustainable as foreigners lose their appetite for US assets. Last month, Japan was a net seller of US securities. The dollar sold off following the report on the market’s fear that this might foreshadow a longer-term trend of Asian central banks reducing or even dumping their extraordinary holdings of US treasuries. Although one month can barely be used as reference for a longer-term trend, if this does becomes a reality in October’s report, not only would the dollar face a deeper slide, but the US economic recovery could be threatened as Treasury prices fall and yields soar.

To the disappointment of many, the Federal Reserve raised interest rates by 25bp to 2.25% and left their statement virtually unchanged. The 2 only modifications were in their assessment of the labor market and reference to energy prices. With the disappointing November payroll report, they downgraded the assessment to “continue to improve gradually” from “has improved.” They also injected the word “earlier” before energy prices, indicating that higher oil prices are still having a lingering impact on the currency markets. There was a lot of speculation that they would signal their concern with rising inflation and possibility omit the phrase “measured” from the statement. Neither was done, which means that the Fed will continue to raise rates gradually. The dollar sold off on the release, which is indicative of the market’s disappointment that the Fed did not support the dollar with a harsher stance on the course of tightening. Meanwhile the trade deficit widened to $55.46bn from $50.9bn as the record high in oil prices (hit during the month of October) boosted the value of imports. Industrial production increased a more than expected 0.3% while capacity utilization improved marginally (from 77.5% to 77.6%). The Manpower Employment Outlook survey suggests that there will be healthy job growth in the first quarter. Approximately a quarter of the employers surveyed expect to increase hiring while 10% expect to decrease hiring. Unfortunately, these stronger reports were not enough to shake off the dollar bearishness brought on by the wider deficit and disappointing FOMC statement.

A wild rollercoaster for most of the session, the British pound ended up higher against the greenback as speculation arose after the consumer price report. According to the data, consumer prices rose more than expected by 1.5 percent compared with earlier estimates of 1.3 percent year over year. Housing and transportation costs also accelerated survey results. In October, housing costs soared 5 percent higher while transport costs advanced 4.1 percent. As a result, investors bid the currency higher in hopes that current inflationary conditions warrant an additional increase in early 2005, which is probably wishful thinking. This is contrary to earlier beliefs that monetary tightening was no longer needed as more stable valuations were seen earlier in housing and producer prices. Additionally, support for the pound looks to be garnered through cross boarder mergers involving multi-billion pound bids for Novar Plc and the London Stock Exchange.

Sluggishly appreciating during the session, the Japanese yen remained relatively rangebound as investors anticipate the release of the quarterly Tankan survey. Economists are expecting a decline in corporate sentiment as sharply rising oil prices and rapid currency appreciation has dampened domestic demand and hurt overall exports. With previously disappointing industrial production data released yesterday, a decline in the survey may confirm what most are already dubbing a recessionary environment in the world’s second largest economy. Ultimately, any short term bullish sentiment would have to come from a positive reading in this week’s leading economic index. On a positive note, however, was a decline in bankruptcies for the month of November. Falling 4.5 percent, this marks the 27th month of decline in solvencies for the economy.


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