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Tuesday July 5, 2005 - 20:41:04 GMT
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Dollar Extends Rally As Market Contemplates 4% Rates

DailyFX Fundamentals 07-05-05

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

∑ Dollar Extends Rally As Market Contemplates 4% Rates
∑ Pound Extends Slide Despite Better Data
∑ Surge in Oil Prices Keep USDJPY Bid

US Dollar

Traders coming back from the holiday weekend will find dollar strength persisting into non-farm payrolls week. Since the beginning of the year, the dollar has rallied 15 percent against the euro to the highest level in 14 months. Nothing has changed over this past weekend with the marketís rationale for the continuation rally still being the Federal Reserveís aggressive interest rate hikes. Circulating in the market this morning was talk of 4 percent interest rates thanks to a sharp leap in the October Fed Fund contracts. We are seeing the market price in an increasing likelihood of two more interest rate hikes between now and October, which means that we may see consecutive quarter-point hikes at the August 9th and September 20th meetings. However one external factor that we are also observing that could cut short the dollar rally is increased signals that a top may be developing in the housing market. With the real estate market booming for so many years, we do not want to jump the gun and call for an end that may not see until a year or two from now. Yet, the signals are there, making them hard to ignore. One of the primary catalysts for the marketís boom over the past few years have been the Federal Reserveís interest rate cuts. Now, the tables have turned and the Fedís rate hikes are pushing the costs of mortgages higher. Real estate investors for the time being have been sheltered by low long-term yields, but the longer that rates remain low, the more compelling the reason the Fed has to fix this anomaly. The real estate market is a speculators market Ė this weekendís Baltimore Sun reported that two-thirds of the houses sold this year have been to investors. According to a CNN interview with Aaron Brown, in Los Angeles, the number of homes sold that have been owned for less than six months jumped 47 percent in a year. The rise in rates is already beginning to have an affect on the market. Massachusetts reported last month that the number of homes sold plunged 11 percent. Existing home sales on a national basis fell in the month of May while new home sales, increased, but far short of expectations. The performance of the housing market is very important to watch because US consumer wealth and spending habits have become very much tied to the value of their homes. In the past, consumers were banking on Internet Stocks for retirement, now it is their housing market investments. Should house prices tip over, like they are beginning to in Australia and the UK, we could very well see a mirror image of the poundís price action in the dollar.

Euro

The recent weakness in the Euro continues to be mostly beneficial for the Eurozoneís economy. Retail sales for the region increased 1.1 percent, which pretty much erases last monthís fall. German retail sales came in particularly strong rising 2.7 percent compared to a 0.7 percent slide the previous month. ECB officials continue to oppose a rate cut, with Market News even reporting that central bank officials may be discussing the possibility of raising rates. Yet not all news was good news. Unlike the manufacturing sector, the service sector did not rebound, but thanks to strong consumer spending in France, the fall in the index was limited. The ECB meets this Thursday to discuss interest rates Ė they are expected to confirm their overall neutral stance.

British Pound

We have yet another session of bleeding in the pound as traders shorted the currency for the sixth consecutive session. An improved service sector PMI and better than expected BRC retail sales number failed to stop the currency pair from losing approximately 800 pips in 6 days with no reprieve in sight ahead of the Bank of Englandís interest rate announcement on Thursday. Citing further confirmation of a slowdown in consumer spending as the reason for keeping rates unchanged, more central bankers may side with the cut this time around as individual consumption has dipped slightly along with consumer confidence. Additionally underpinning the notion has been lackluster industrial and manufacturing production reports. However, remaining a concern on the minds of central bankers has been consumer borrowing figures. For the month, consumer lending actually increased as did net lending on residential housing. A decrease in short term interest rates, although beneficial as it spurs economic activity, may in fact lead to further inflation of both figures. Creating fears of a potential credit bubble, this may hinder any firm bets on a definitive decrease in benchmark rates by policy makers on Thursday, suggesting that policy makers may subsequently pass on moving once again, postponing any major decisions until August.

Japanese Yen

No economic data, not a problem. Traders took to the data absent session in pounding the currency lower as crude oil prices regained their strength on temporary supply concerns. An impending tropical storm centralized in the Gulf Coast led traders on the NYMEX to push the commodityís price higher, testing the $60 a barrel resistance. With the land of the rising sun importing 98 percent of its oil, the growth that we witnessed earlier in 2005 could be in jeopardy, especially as it may affect timid consumers. On the brighter side, this could solve the persistent deflationary concerns as higher producer prices would ultimately trickle on to the consumer, leading to a whole new can of worms. Separately though, and the foremost reason on yen bearishness, looks to be the confirmed emergence of the 2005 carry trade. With the Federal Reserve lifting, as expected, interest rates to 3.25 percent, benchmark rate spreads have now widened to a whopping 325 basis points. This offers an investor the advantage of not only gaining from the inherent upward appreciation, but also accruing a significant amount of interest. Regardless of either rising oil prices or the carry trade bandwagon, further downside may be forthcoming in the currency until there is a significant improvement in the economy and monetary policy can be established.

 

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