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Tuesday June 7, 2005 - 21:48:00 GMT
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Forex: Dollar Unchanged As Market Contemplates Why US Long Term Rates Are So Low

DailyFX Fundamentals 06-07-05

By Kathy Lien, Chief Strategist of www.dailyfx.com

· Dollar Unchanged As Market Contemplates Why US Long Term Rates Are So Low
· Comments From Trichet and Issing Suggests That ECB Is In Neutral Mode
· Pound Shrugs Off Weak Retail Sales and Declining House Prices

US Dollar

Trading in the US dollar continues to remain very quiet with consumer credit being the only notable piece of data released today. Consumer credit came in far below expectations, increasing only $1.3B in April, which may be indicative of slowing consumer spending. Thanks to Fed Chairman Alan Greenspan, the market seems to be transfixed on the extremely low levels of long term yields in the US today. This morning in our Market Brief we talked about the near flat yield curve, but Greenspan also warned last night at an IMF conference in Beijing that the yield curve could even become inverted. His best guess is that the market expects the economy to weaken in the months ahead, which he thinks is a “credible notion.” Yet no reason provides a perfect explanation for the “conundrum” since some of the buying could be attributed to foreign demand for US debt. This makes perfect sense to us since over the past few months, a lot of activity in the US dollar has been related to carry trades. Before the Fed began raising rates from 45-year lows of 1%, the dollar was the one of the most popular currencies to sell for carry trades. (In carry trades, a high interest rate currency is bought against a low interest rate currency with the goal of capturing the yield differential) Now that the Fed has increased rates by 200bp to 3%, short dollar carry trades are no longer as profitable, prompting these investors and traders who have sold the dollar and US treasuries to buy back those dollars and treasuries and close their positions. Alternatively, with the Fed aggressively raising rates, we also have some investors who are interested in the dollar and US treasuries as a new emerging carry trade. There are of course other reasons as well such as pension funds scrambling to buy long-term bonds to make up for unfunded liabilities and expectations for lower inflation in the future. Greenspan avoided talking about monetary policy directly and reiterated his view that China needs to revalue at some point and he expects it to happen soon. Yet he also believes that a revaluation by China will do little to fix the US’ trade imbalances. Meanwhile, GM announced plans to close factories and layoff 25,000 people. Although this will be done over the next 3 years and some people may just be reassigned different jobs within the same company, it highlights the weakness in the overall manufacturing sector.

Euro

Trading in the euro has been fairly quiet with prices ending relatively unchanged for most of the session. What the ECB will and should do with interest rates continue to be the talk of the markets today. The IMF joined the chorus of voices calling on the ECB to cut rates if growth fails to accelerate. In contrast to the comments by ECB Issing, ECB President Trichet himself said that the central bank “was not preparing for a rate cut.” However, to hedge himself, he did add that the central bank would continue to go through data with a fine toothcomb to make sure that they act appropriately. This suggests that the ECB has essentially dropped their tightening bias and is now in neutral mode. The only important piece of economic data released this morning was German industrial production, which doubled expectations, increasing an impressive 1.1% in April. Even though the German economy continues to struggle, today’s report provides us with some glimmer of hope.

Pound

The British pound rebounded strongly for the second consecutive day ignoring weaker economic data. The two house price indices released this morning confirmed the weakness that we have begun to see in the US housing market. Not only did the HBOS and FT house prices decline in May, but the April numbers were also revised downward. The BRC retail sales index released last night was also very weak. According to the report, retail sales fell by the largest amount in over 10 years. The market is even pricing in the possibility of a rate cut some time this year. December 2005 short sterling futures are currently yielding 4.54 percent.

Japanese Yen

Dollar yen has sold off for the fourth consecutive day ahead of this weekend’s G7 finance ministers meeting. The market expects finance ministers to continue to exert pressure on China to revalue its currency. China on the other hand stands staunchly behind their resistance to international pressure. People’s Bank of China Governor Zhou said last night that even though China has a “strong determination” to move to a more flexible exchange rate regime, they are not ready to do so at this point. Meanwhile Japanese household spending increased a weaker than expected 1.0% in the month of April, pushing the annualized pace of growth lower by 3.0%. Domestic demand in Japan has been very weak, which is particularly concerning since consumer spending accounts for 55% of GDP.

 

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