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Monday August 8, 2005 - 21:46:49 GMT

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No Surprises Expected From Fed – 4.25% Rates a Growing Possibility

DailyFX Report 08-08-05

By Kathy Lien, Chief Strategist of

· Dollar Muted, No Surprises Expected From Fed – 4.25% Rates a Growing Possibility
· Pound Rallies as Producer Prices Grow By Fastest Pace in 20 Years
· Yen Slides on Rejection of Postal Privatization Bill

US Dollar

Even though non-farm payrolls came out strongly on Friday, the dollar has already given back most of its gains. For the new traders that are just beginning to follow our commentary, what we have been seeing lately is characteristic of traditional market behavior in the month of August. With practically all of Europe taking the month off and US traders opting for four day weekends, most of the currency pairs are range trading. The only chatter that we are really hearing in the markets today is that oil prices continued to climb higher, registering yet another all-time high of $64 a barrel. Fears of terror attacks in Saudi Arabia have prompted the US to close down its embassy as well as 2 consulates. Iran, OPEC’s second largest oil producer has also resumed its nuclear program, which means that they face the risk of sanctions as well as international backlash. Geopolitical risks are running high and sending oil prices higher, which increases the uncertainty of future US consumption. Yet with a strong retail sales number expected on Thursday, we think that the market will easily forget that the US consumer faces the risk of higher energy or gasoline bills as well as the growing possibility of a housing market collapse. In the meantime, everyone’s attention is now on tomorrow’s Federal Reserve rate decision. The Fed is expected to increase interest rates by a quarter point to 3.75%. We do not expect Alan Greenspan to deliver any big surprises tomorrow afternoon. With the recent trend of US data, the Fed will probably be more optimistic on the health of the US economy as well as warn about growing inflation risks – all of which points to no pauses until November. At the beginning of last week, the market was only pricing in two more rate hikes to 4.00%. Right now, we have 4.25% a near certainty.


Another day, another piece of stronger Eurozone data. Retail PMI rose to 51.0 from 49.1 in the month of June. The retail sales index for Germany and France are both in expansionary territory and even though Italy’s index remains in contractionary territory, it did leap from 43.3 to 48.8. Italy continues to be the laggard with industrial output falling more than expected in the month of June. All countries in the Eurozone are plagued by most of the same factors, but the relative backward and uncompetitive nature of Italy’s industry has also slowed their reaction to stimulus. The market is becoming increasingly optimistic about the health of the European economy and as a result, the single currency should continue to benefit from quiet, yet strong demand for their currency from the Asian region.

British Pound

The British pound climbed higher today thanks to growing inflationary pressures. Producer prices increased 1.8% last month, which is the fastest pace in 20 years and can be compared to expectations for 1.3% growth. For reasons such as this, we do not expect to see a follow-up to the interest rate cut that the Bank of England delivered last week. Yet the central bank’s decision is never an easy one. According to the Office of the Deputy Prime Minister, house prices increased by the slowest pace in 18 months in June. The central bank may be hoping that their first rate move in over a year could also have a psychological impact on spending. In the meantime though, as much as we can forecast no more moves by the BoE for the remainder of this year, in reality, this will be contingent upon how the economy and economic data fares over the months ahead. If the global economy slows as a result of high oil prices and export demand falls significantly, the BoE may have to put growth ahead of inflation and deliver yet another move.

Japanese Yen

What a political mess - the Postal Privatization bill was rejected last night which means that Koizumi will have to hold general elections within 40-days. The election has already been scheduled for September 11. The dollar skyrocketed against the Japanese yen on the disappointment, but the Yen quickly retraced the losses as the market had already discounted the higher possibility of the bill actually being rejected than accepted. There is a great article in the Financial Times that talks about how confused the Japanese public is on the benefits of the postal privatization bill and how their government have plunged themselves into such a crisis and face the possibility of dissolution because of this bill. Although there is still political uncertainty with a general election scheduled next month, the immediate economic impact should be limited. Koizumi's economic reforms are pretty much underway which means that they will be very difficult to repeal while large tax hikes that Koizumi has been considering will probably now be put on the back burner. In the meantime, fundamental factors should return to the forefront. Recent data has been pointing to improvements in the Japanese economy. So far, the country has been able to shrug off the latest strength in oil prices without significant additional weakness in the Japanese Yen. It remains to be seen though whether such a large importer can continue to whether the higher costs of energy.


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