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Monday July 25, 2005 - 21:46:31 GMT
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Dollar Recoups Losses as Traders Shift Focus Away From China and Back To Interest Rates

Daily Forex Report 07-25-05

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

· Dollar Recoups Losses as Traders Shift Focus Away From China and Back To Interest Rates
· Pound Continues to Get Pounded On Talk of Rate Cuts
· Bank of Japan Expected to Leave Rates Unchanged

US Dollar

It has been fairly quiet in the currency markets today with the economic calendar extremely light and the market still assessing the potential implications of China’s exchange rate regime change. For the most part, the majors except for USDJPY has given back most of its China-induced gains or losses. The size of the move seems to be a disappointment for many while the time table for any additional announcements is still unknown. This weekend’s papers were littered with different views about what China will do next and what this means for the markets. Most expect more moves to come and significant longer-term ramifications. As a result, we could be waiting weeks or even months before China makes another move. So in line with the market’s short attention span, traders have already shifted some of its focus back to the interest rate story. With the US expected to raise rates once again in August and the ECB continuing to stand pat, the dollar’s longer term concerns and even the US’ call for more currency flexibility from China has fallen to the sidelines. However we caution traders from brushing aside China’s announcement too quickly. The head-honcho of monetary policy, Central Bank Governor Zhou confirmed that this is an “initial 2% adjustment” and that they will gradually continue to reform the country’s exchange rate system. As time progresses, currencies such as the Japanese yen and the Canadian dollar will be the most heavily impacted with Japan getting a boost in external competitiveness and Canada benefiting from what is pretty much a 2% discount on their commodity exports. When the components of the managed float basket is announced, we expect another sharp move higher in the currencies that are to be included in the basket. Like Singapore, China will probably refrain from disclosing the actual percentage breakdown of the basket. In the meantime though, while we are waiting for China to make another announcement, we expect to see more talk of China’s appetite for snapping up companies around the world, including here in the US. This interestingly timed move (less than a week after the US time-stamped a possible move), seems to be more like a political compromise than anything else. Meanwhile here in the US, we have a fairly busy week with the Beige Book, durable goods, Chicago PMI and GDP on the calendar. Existing home sales surged to a record high in June, confirming that the Federal Reserve will have more work to do in the months ahead.

Euro

The Euro ends the day virtually unchanged. Higher inflationary pressures in Germany fails to shift the overall sentiment in the Euro. Import prices surged 1.6% in June thanks to higher oil prices while consumer prices in Bavaria and the North-Rhine regions both accelerated this month. If China begins to accumulate Euros and parks these purchases into German bonds, we expect bond prices in Europe to move higher and yields to gradually decline, which would be comparable to a rate cut by the ECB. This could deliver some much-needed additional stimulus to the region. Thinking out loud, it is pretty interesting to us how much sway China now has on the global economy and how they may be able to effectively manipulate other country’s monetary policies through their reserve accumulations and sales. Last Thursday, there was an article in Barron’s online titled “Federal Reserve Responsibilities Outsourced to China.” Although it is an opinion piece, the possibility of this being true is certainly fascinating.

British Pound

Continuing to consolidate, the British pound continued to be bias towards the downside ahead of several key reports this week. Although most have connections with housing price valuations, the CBI industrial trends survey tomorrow will be of immediate interest as it reflects shifts in manufacturing trends. Hopefully, the survey can shed some light on the rather lackluster manufacturing and industrial production data that we have seen thus far. Ultimately this will lead to what is currently on the minds of most market participants, the upcoming Bank of England meeting. Scheduled for August 3rd and 4th, monetary policy committee members could very well vote in favor of cutting rates after having left them at 4.75% for the year. The decision though is all but certain given the recent pick up in retail sales and higher inflationary pressures. In the latest MPC minutes released last week, the margin was as narrow as it can can get. Five members of the MPC voted in favor of keeping rates unchanged compared to 4 who opposed it. Policy makers though may look to first prop up consumer spending and demand in light of further increases in housing valuations and the ever present consumer lending problem. Separately, Tony Blair today called for an increase in the minimum age of retirement to 67. Although vehemently opposed, the call is in order to tackle an impending pension crisis that is growing in the U.K. Without the increase, the state pension would fall short and endanger millions with poverty in the future.

Japanese Yen

Besides nationwide department sales soaring past earlier consensus, traders had very little to consider in trading the Japanese yen today. This gave the market a chance to catch its breath after the volatile end to last week. Next on tap looks to be the Bank of Japan policy meeting. Although rates are expected to be left unchanged, a revision to the current account balance target remains viable. Already sustaining a zero rate policy, central bankers have recently turned their attention to the current account target, between 30-35 trillion yen in implementing monetary policy and keeping to their quantitative easing policy stance. However, with deflationary pressures easing and consumer demand gaining relative strength, policy makers may ultimately opt to shift monetary policy and adjust the balance target to accommodate to a more inflationary environment. This is contrary to some as short term interest rates look to be the first in being adjusted rather than balance targets. However, for this to occur, consecutive quarters of considerable price increases may have to take place in convincing policy figure heads to stray from the more conservative approach. However, with China revaluing their domestic currency and crude oil prices rising back to the $60 a barrel level, this notion may not be so easy to toss to the side in the future.

 

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