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Wednesday May 4, 2005 - 21:18:01 GMT

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Forex: Dollar Extends Sell-Off As Fed Pigeon Holes Itself

DailyFX Fundamentals 05-04-05

By Kathy Lien, Chief Strategist of

· Dollar Extends Sell-Off As Fed Pigeon Holes Itself
· Trichet Says Rate Cuts Not Possible
· China Warns That Too Much Speculation Makes Revaluation Difficult

US Dollar

The US dollar continued to weaken after yesterday’s FOMC meeting. The shock of the mysterious missing phrase still hangs over the markets and we probably wont see any respite until Friday’s non-farm payrolls report. Of course, it will take a strong number for us to feel the wind blow against the dollar’s back once again. As we mentioned yesterday, the measured phrase is set to disappear soon since US interest rates is only a hair short of the inflation rate. Today, we want to elaborate further and warn of events to come. Even though the Fed is bound to drop the phrase measured, that does not necessarily mean that they want to increase the pace of tightening. The Fed has pigeon-holed itself by giving the market a phrase to focus on and they are trying their best to back off from the phrase without sending shockwaves to the market. For this very reason, they chose to upgrade nearly every word in their March statement while still leaving in the words measured and accommodative. If they stop raising rates, both of these phrases would also have to disappear. For the past few months we have been saying that the Fed will stop raising rates once they reach the “neutral” level, which doesn’t spur growth or inflation. However, what value represents the neutral rate still remains up for discussion. The market estimates that rate to be between 3.5%-4.5%. Pimco’s Gross had already expressed his opinion that the Fed will stop at 3.5%. So far, data has been mixed with a bearish bias, which supports Gross’ arguments, but whether this holds true or not will continue to hinge upon future economic data. That is why the market will center its focus on Friday’s NFPs, which is one of the most important economic releases on the US calendar.


The European Central Bank left interest rates unchanged once again at 2 percent, confirming their status as the longest central bank to keep rates on hold amongst the countries that we follow. Recent speculation surrounding a possible rate cut by the ECB made the post-meeting press conference conducted by Trichet particularly interesting. Trichet essentially eradicated any expectations of a move by the ECB in the near future. For those calling for a rate hike by the central bank later this year as a result of rising inflationary pressures, Trichet said that there are no signs of underlying inflation pressures and that inflation should stay at current levels over the next few months. For those calling for a rate cut, Trichet said explicitly that cutting interest rates is not an option for the ECB. So basically this leaves us right back at square one. In terms of economic data released today, service sector growth slowed in the month of April, but did not dip into contractionary territory like the manufacturing sector. Retail sales were also slightly encouraging, coming in stronger against expectations, which had forecasted a decline.

British Pound

Like the euro, the British pound rebounded against the dollar thanks to a rise in construction sector PMI as well as broad dollar weakness. Tomorrow is the much-awaited general election in the UK. Barring any unforeseen circumstances, the Labour Party and Prime Minister Tony Blair will be a shoe-in for reelection. Once this event risk is over, the market will begin talking about Monday’s BoE rate decision. The date for the central bank meeting was postponed to this weekend due to the election. Ninety four percent of the economists surveyed expect the central bank to leave rates unchanged at 4.75%. The other remaining economists expect a rate hike. However given the divergence in economic data from the UK as of late, it is unlikely that the BoE will be changing monetary policy any time soon.

Japanese Yen

Japanese markets were closed once again last night, but that didn’t stop the USDJPY from seeing some intra-day volatility thanks to more talk of Chinese revaluation. China seems pretty frustrated with the recent speculation surrounding the Yuan, especially since NDF forwards have been widening significantly as of late. The yen sold off against the dollar today as Chinese Finance Minster Jin Renqing said that, “too much speculation makes it difficult to implement reform of the exchange rate system.” Even so though, this hasn’t stopped economists from predicting a revaluation to occur as early as two weeks from now. This time frame, proposed by Goldman Sachs is shocking to us, but Goldman argues that May 18 would be a very convenient time for China to announce a shift in their decade old peg. May 18 is the date that China is scheduled to increase the number of currencies that its member banks trade from four to twelve. According to Bloomberg, Morgan Stanley projects a move in June following the G7 meeting while HSBC expects China to delay a move to 2006.


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