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Tuesday August 9, 2005 - 20:35:37 GMT

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Forex: Fed Rate Hike Does Little For Dollar

DailyFX Fundamentals 08-09-05

By Kathy Lien, Chief Strategist of

· Fed Rate Hike Does Little For Dollar
· Widening Gap - German Data Continues to Improve while Italy’s Outlook Gets Downgraded
· UK Government Claims that Criminal Activities Could be Distorting Trade Balance

US Dollar
Now that the Federal Reserve rate decision is behind us, it is time to turn our focus to two key pieces of US data due out this week – retail sales and the trade balance. The Fed’s optimism about consumer spending confirms our belief that Thursday’s number could be explosive. Higher oil prices should boost gas station receipts while the auto industry’s incredibly successful “employee discount” incentive is expected to drive strong auto sales. The trade deficit on the other hand will paint a bleaker picture with the surge in petroleum prices expected to widen the deficit in the month of June. If you recall, the deficit narrowed in the month of May but the number was distorting because the data was too backward looking to include the 38% surge in oil prices that we have seen since the low it hit in May. We saw no surprises at the Fed’s interest rate hike today. The Federal Reserve increased interest rates by a quarter of a point for the tenth time from 3.25% to 3.50%. The dollar sold off modestly on the back of the announcement because the Fed failed to upgrade their inflation assessment, as many traders have been expecting. The actual tightening itself was completely discounted by the market. The FOMC statement did take a more optimistic tone though on spending in the face of higher energy prices (which is an improvement in the economic outlook), but according to the Fed, core inflation remained relatively low. They also think that the current pressure on inflation remains elevated (only change being the elimination of the word "long-term"). With the recent improvements in US data over the past few weeks, there continues to be a good chance that the Fed will continue raising interest rates to 4.25%. The Fed does have to be careful about tightening the economy too much. As interest rates increase, mortgage costs also rise. Given that consumer wealth these days is very closely tied to the housing market, a correction in the housing sector could send US consumption and therefore the US economy, tumbling – especially if oil prices remain above $60 a barrel.

To say the euro is resilient may be an understatement. In the face of strong US non-farm payrolls, another Federal Reserve interest rate hike and the prospect for a blockbuster retail sales report, the single currency has held on strong. Economic data continues to reflect improvements with Germany’s trade surplus increasing to EUR16.8 billion in the month of June from EUR12.1 billion in May while wholesale price growth accelerated by a faster rate. Yet as we have repeatedly mentioned, the out performance in Germany has not been replicated across the continent. Italy continues to struggle. After cutting Italy’s long-term credit rating from AA to AA-, Standard and Poor’s has now lowered the country’s rating outlook from stable to negative. If Italy fails to fix its finances, there could be another downgrade in 18 months. The country slipped into a recession in the first quarter and has still been struggling to come out of it. A high budget deficit and the uncompetitiveness of Italian industry have widened the gap between Italy’s growth and the growth of its neighbors.

British Pound
Today’s economic release from the UK helps to justify the 25 basis point rate cut delivered by Bank of England last week. According to the British Retail Consortium survey, retail sales dipped 1.9 percent in the month of July on like-for-like sales, making it the worst July since 1995. Consumers remained cautious last month as high debt still plagues the individual British consumer and lower housing valuations dim consumption interests. However, although the BRC is calling for further rate cut decisions, policy makers may ultimately want to see how the latest interest rate cut impacts the economy before making any additional considerations. Notably on the day, traders and economists witnessed the U.K. trade balance narrow, considerably better than consensus expectations. However, concerns over the legitimacy of the data surfaced as government officials claimed to uncover tax frauds that distorted the figure. According to British government officials, criminal activity seems to be skewing recent trade data as exports to non-EU nations vaulted considerably higher in the month. Most notable have been shipments to Dubai, Nigeria and Russia. As a result, a cloud of “uncertainty” has been cast over the report and calls for further transparency have risen.

Japanese Yen
Central bank officials released a second consecutive upbeat outlook for the economy today after leaving rates unchanged once again. Citing progress in inventory reduction, policy makers added that industrial production also looked favorable as export volume increases. Subsequently, they also mentioned a pickup in employment prospects and wage growth as companies continue to increase fixed capital investment. Visibly more optimistic this time around, policy officials still maintained caution for lingering deflation, reiterating previous statements that consumer prices would have to increase considerably before rate hike considerations could take place. Separately, with the election date set, speculation has now arisen over the possibility of Prime Minister Koizumi bringing a referendum to the table as well as the effects of an ultimate resignation given the bill is rejected for a second time. Although it seems as though the political risk has been minimized as a pseudo result for now, future uncertainty may weigh heavier as we approach the ultimate deadline.


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