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Forex: Euro Rebounds As ECB Not Likely To Follow In Sweden’s Footsteps

DailyFX Fundamentals 06-21-05

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

· Euro Rebounds As ECB Not Likely To Follow In Sweden’s Footsteps
· Dollar Gyrates On Fed Interest Rate Debate
· Yen Rallies Fresh Speculation About Yuan Revaluation

US Dollar

Watching the dollar trade today is like watching a kid ride a see saw. The greenback soared following the Swedish central bank’s surprise 50bp rate cut this morning, leading some in the markets to believe that the Riksbank’s move puts the pressure on the ECB to follow suit. Yet Sweden is in a very different situation than the Eurozone, which we will cover in more detail in the Euro commentary. Interest rates have also been the talk of town here in the US. Bloomberg Fed Watcher John Berry and Morgan Stanley Chief Economist Stephen Roach called for rates to be hiked more aggressively to as high as 5% while Pimco’s Bill Gross wants the Fed to stop at 3.5%. Quoting a few Fed officials, Berry claims that inflation remains a risk and that the 200bp rate hikes thus far have had less of an impact on slowing the economy than Fed officials may have hoped because long-term rates remained very low. Gross on the other hand expects growth to slow over the next six months. As a result, he thinks that the Fed will stop raising rates at 3.5% in August. Surprisingly though, he takes this belief one step further and talked about how the Fed may even be considering cutting rates at the end of the year. Two extremes on a very important issue make it clear that the September decision is very much up in the air. We side more with Gross than Berry given the recent trend of economic data, but stop short of the rate cut theory. The dollar is doing a good job of holding onto its gains despite today’s retracement, but once we get whiff of the end of the tightening cycle, all those who are in Berry’s and Roach’s camp could capitulate, sending the euro soaring. On the flip side, if come August, we see signals that the Fed will continue on track with raising rates in September, Bill Gross and his friends will also have to adjust their positions appropriately.

Euro

The big news in Europe today that led to the initial slide in the Euro was the surprise rate cut by Sweden’s central bank. This led the market to immediately begin talking about whether this will pressure the ECB to cut rates as well. This is highly unlikely since Sweden is in a very different position than many of its counterparts. In contrast to the Eurozone, Sweden is facing deflationary pressures. Annualized inflation has fallen to 0.2% yoy last month from 0.4% in April. Inflation in the Eurozone on the other hand was 1.9% last month. Both countries are facing weak growth of comparable levels and have a 2.0% inflation target. The numbers alone though tells us that Sweden has a much more pressing reason to lower rates than the ECB. With oil prices up 29% from last month’s low, and the EURUSD 7% lower, we will probably see inflation either above or back at the central bank’s target. Despite the persistent calls for a rate cut, this will keep the ECB’s hands tied for the time being. According to a survey by the ZEW Institute, only 8% of German investors expect a rate cut. ECB members Noyer and Liebscher were on the wires confirming that interest rates are appropriate and that the central continues to watch oil prices. Meanwhile, the ZEW survey of economic sentiment for Germany came in stronger than expected, rising to 19.5 from 13.9.

British Pound

Vaulting significantly higher during the session, the British pound benefited from increased interest in UK fixed income markets and speculation that Prime Minister Tony Blair considered abandoning the 21 year old EU rebate, lightening the uncertainty that has plagued the currency. Following a morning meeting with Swedish Prime Minister Goran Persson, Blair suggested that he would be willing to forego the lucrative rebates issued to Europe’s second largest economy. However, he also stated that there existed a need for the EU to additionally move to an improved financing structure, namely referring to an overhaul of the popular farm subsidies that constitute 40 percent of the overall budget. However, opposition still remains from French President Jacques Chirac, unwilling to budge on the EU financial support, and other member states as blame shifts to the UK prime minister on the breakdown of the summit. Separately, UK bond markets rose on the session as a result of heightened foreign interest for the higher yielding instruments and anticipation that the Bank of England will elect to cut the benchmark repurchase rate when they next convene. As a result, with UK gilts “in favor”, demand for spot may further the recent cable strength. The major risk though will be tomorrow’s Bank of England minutes. Recent data suggests that the one dissenting member voting in favor of a rate cut at the last meeting could have shifted stances and rejoined his peers in the neutral camp.

Japanese Yen

Bulls came out of hiding today and pushed the Japanese yen higher as optimistic sentiment flooded the market on continued Yuan speculation and expectations of a pickup in the demand for services in the world’s second largest economy. With confirmation that Chinese President Hu Jintao would be attending the Group of Eight annual summit on July 7th, traders took the opportunity to add to long yen positions on speculation of forthcoming revaluation efforts. However, doubt still remains as to the speed at which such a historic move may occur. Chinese officials known for their propensity to maintain an air of independence from external political pressure are still said to be considering the topic with most analysts expecting no final decision till 2006. Bolstering the competitiveness of Japanese exports, an appreciated Chinese Yuan may also spark interest in Asian based economies and further foreign investment in the region. Additionally, mounting expectations of a bounce in demand for services through tomorrow’s tertiary index release added to yen strength. Declining from a high of 2.4 percent in January, a rebound to 1.5 percent could be suggestive of a revitalization of consumer demand and further capital spending. With the sector comprising over 60 percent of the economy, a higher reading may bolster a positive outlook and confirm recent optimism by policy makers.

 

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