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Friday July 29, 2005 - 20:31:38 GMT

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Forex: Will the Bank of England be the First to Cut Rates?

DailyFX Fundamentals 07-29-05

By Kathy Lien, Chief Strategist of

· Will the Bank of England be the First to Cut Rates?
· Dollar Slips As GDP Falls Short of Expectations
· Another Batch of Stronger Eurozone Data Will Keep ECB on Hold

US Dollar

The dollar took a nosedive after this morning’s GDP report as the numbers tell us that the US economy is growing, but at a slower pace than last quarter. GDP accelerated by 3.4% in the second quarter, down from 3.8% in the first quarter. The disappointment was only a mere 0.1%, but there were a good number of traders in the market expecting a much stronger number following the recent chain of improving US economic data. As a result, we saw a sharp slide in the dollar against the euro. However at least half of those losses were recouped as the market realized that even though inventory growth dragged overall growth lower, other parts of the GDP report did give a cause for optimism. More specifically, final sales surged 5.8% in the second quarter, up from 3.5%. The recent narrowering of the trade deficit also added 1.57% to GDP, which was the largest contribution since 1996. Overall, exports increased by 12.6% while imports fell. It still remains to be seen whether the shrinking of the trade deficit will continue given the elevated level of oil prices. Another sliver of hope for growth was the 9.9 point surge in the Chicago PMI report. After this week’s stronger durables goods orders report, there are more and more signs of a recovery in the manufacturing sector. With the housing market and manufacturing sector both holding on strong, the case builds for another optimistic statement from their Fed in a week and a half. Non-farm payrolls is due for release next Friday, which should be the focus of the market next week. Based upon the recent string of data, we expect another strong triple digit increase. This means that for the time being, even though inflation reports are diverging from the trend of oil prices, there is no stopping the Fed.


Aside from German retail sales, today brought on another batch of stronger Eurozone data. For most of this past week, we have been seeing more evidence of a recovery and a turnaround in the Eurozone economy. Following yesterday’s drop in German unemployment, French unemployment also fell by 28,000, which is the first time in 5 months that the country has seen an improvement in the labor market. Unemployment in Spain also hit a record low in the second quarter. Thanks to the improvements, Eurozone economic confidence rose from 96.3 to 96.7. Yet confidence was not completely widespread as French consumer pessimism remained at a record low. German retail sales fell 0.3% in June, but an upward revision to the May data offset most the increase. The flash estimate of Eurozone headline inflation increased to 2.2% from 2.1%. Taken together, improving data and rising inflationary pressures in the Eurozone will continue to keep the ECB’s hands tied from lowering rates even though politicians in Italy are complaining about the disastrous effect the Euro has had on growth. As a result, we do not expect any surprises at next week’s ECB meeting. Trichet and his team should remain committed to keeping monetary policy unchanged.

British Pound

The British pound grinded higher for the third consecutive day thanks to a rebound in UK consumer confidence. Given that the most recent release includes sentiment following the London attacks, the improvement was probably attributed to UK consumer expectations for a rate cut by the Bank of England. This is the first meeting in a long time where we have the market and economists somewhat divided on the outcome. Most economists do expect a quarter point rate hike on August 4th, but based upon the latest price action, it does not seem that the market is as convinced of a move. There is good reason for traders to stand on both sides of the fence. While the BoE could deliver a rate cut to spur optimism following the London attacks, especially since last month’s vote was on a narrow 5-4 margin, the strength of the latest retail sales report and recent rebound in confidence as well as still buoyant inflationary pressures could tempt them to keep rates unchanged for yet another month. Regardless as we currently stand, the Bank of England is on its way to becoming one of the first major central banks to cut rates this year. It seemed as if it was only yesterday, that they were one of the first central banks to raise rates back in November 2003.

Japanese Yen

The Japanese yen sold off modestly today against the dollar despite some rather promising news. Industrial production rose unexpectedly by 1.5% last month while the jobless rate fell to 4.2%, the lowest level in 7 years. China also came out with more contradictory talk. Today the People’s Bank of China Governor Zhou was quoted as saying “from now on, the yuan rates’ fluctuation will not be because of government adjustments.” The market has taken this in stride because for the most part, he is only stating facts - the currency now fluctuates 0.3% based upon the previous day’s rate and not based upon the 8.11 rate that was set on July 21 so the market does have a hand in the currency’s fluctuations. Yet nonetheless, we also know that China has an interest in encouraging a gradual appreciation in the RMB, which will be positive for the Japanese Yen over the longer term. Weakness today could then be attributed to another rally in oil prices and a drop in worker’s household spending. The market had expected spending to increase but it actually fell by 1.4%.


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