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Wednesday August 3, 2005 - 20:37:31 GMT

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Will the UK be the First Major Country to Lower Interest Rates?

DailyFX Forex Report

By Kathy Lien, Chief Strategist of

∑ Will the UK be the First Major Country to Lower Interest Rates?
∑ Euro Breaks Higher Following Another Batch of Good News
∑ Japanese Yen Continues to Soar Ahead of Postal Privatization Vote

US Dollar

As we postulated yesterday, the fourth timeís indeed the charm. The Euro has finally managed to breach the 1.2250 barrier against the dollar on nothing more than another set of positive Eurozone economic data. We had mild disappointments here in the US with a weaker than expected service sector ISM report which eased to 60.5 from 62.2. Given that anything above 60 is still expansionary, the dollar barely reacted on the back of the release. Most of the action occurred in the early European trading session with the dollar gradually grinding lower during the US session. Even an optimistic Challenger report did little to help the dollar recoup some of its losses. According to the Challenger Group, there were 7% less layoff announcements in the month of July compared to the month of June. The 1.2350 barrier is now the next key level, but it is being staunchly defended with lots of rumors of people defending option barriers at that level. Although the market will be paying heed to the rate decisions by the Bank of England and European Central Bank tomorrow, the US session should be spent pondering how non-farm payrolls may fare on Friday. Yesterday we said that non-farm payrolls are expected to be strong in the month of July with the average of jobless claims at 316k compared to the first half average of 326k, help wanted ads are up, layoffs are down while the employment component of the ISM manufacturing survey rebounded back into expansionary from contractionary territory. The employment component of the service ISM remained unchanged. With signs of a recovery across the board in the manufacturing sector, we wouldnít be surprised to see job growth in sector for the first time in 4 months.


The Euro has now rallied for the sixth consecutive day against the dollar. It is becoming increasingly clear that the Eurozone economy has already hit the bottom and is now headed higher from here. Service sector PMI for the region increased to 53.5 from 53.1 in June. Not surprisingly, improvements were seen in Germany, the country that has been benefiting the most from the stimulative effect of the previous sell-off in the Euro. The PMI index for Italy rebounded back to neutral, indicating that the service sector did not grow or slow in the month of July. France however experienced a slide in the index although it does remain in expansionary territory. The real surprise today came in the retail trade index which jumped to 0.4% compared to expectations for 0.1% growth. The icing on the cake was the improvement in the business climate index which rose to 53.2 from 52.3. Overall, the Eurozone is already on the path to a stronger growth for the second half of the year. As a result of the recent turn in Eurozone data, ECB President Trichet could very well make some optimistic comments tomorrow at the press conference following the announcement of the ECBís interest rate decision. The ECB is expected to keep rates unchanged for the 14th consecutive month.

British Pound

The Bank of Englandís Monetary Policy Committee began its two day meeting today to discuss changes in interest rates. This may actually be one of the most interesting meetings that we have had in a while. Although the BoE is expected to lower rates for the first time in a year, skeptics are starting to loom with some experts feeling that the economic situation in Europeís second largest economy is not as bad as they initially expected. However, there still remains some key bits of evidence that make the 25 basis point cut decision the more likely scenario. Declines in manufacturing and industrial production have remained key to proponents of the benchmark rate cut. Additionally, dips in consumer spending and paltry retail sales and volume figures, according to yesterdayís CBI survey, have contributed substantively to the notion. Subsequently, economists are now considering current inflationary suggestions and the fact that consumer spending figures arenít necessarily that bad. Inflation accelerated at the fastest pace in seven years and matched the central bankís target rate of 2 percent. Consumer prices also increased to an annualized 2 percent. This is a factor that policy makers are also wary of as it remains an economic red light. Subsequently, although traders are pricing in a definite reduction decision this time around, sentiment has changed to suggest that policy makers will be reluctant in replicating the decision till 2006 with short sterling futures confirming the shift.

Japanese Yen

The Japanese yen rallied against the dollar for the third day in a row. Relatively odd considering that crude oil prices are still very lofty, the current strength looks to be connected with growing bullish sentiment reflected in Japanese equities and mounting speculation on the deflationary front Rarely noticed in the first half of 2005, the Nikkei 225 has charged ahead in recent months, briefly peaking above the psychological 12,000 mark. Still, closing at a 15 month high, the higher benchmark index looks to be lending some strength to yen bulls. With a seemingly stronger equities market, Japanese investor interest in domestic investment may be renewed, ultimately capping outflows of yen capital which has loomed over the markets. Additionally, widespread belief is that with growing valuations, and additional upticks in the economy, the impact of higher energy costs can now be discounted. Although recent strength, by no means suggest a new bull market, it can attract foreign investors back to the economy. Subsequently, risks still do exist as we approach the voting deadline for Koizumiís effort to privatize the postal service. Hitting the wire today, representatives of the ruling Liberal Democratic party placed pressure on the prime minister in not carrying out the potential dissolution of the lower house. It seems that even staunch advocates of Koizumi may be reconsidering their allegiance if such a situation is created, placing the prime minister in an awkward situation.


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