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Wednesday September 7, 2005 - 21:35:12 GMT

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Forex: Dollar – Could the Fed Deliver a Mid-Cycle Pause?

DailyFX Fundamentals 09-07-05

By Kathy Lien Chief Strategist

· Dollar – Could the Fed Deliver a Mid-Cycle Pause?
· Bank of England Expected to Stand Pat on Interest Rates
· Japanese Data Shows Signs of Weakness

US Dollar - The dollar rebounded for the second consecutive day against the Euro as the post-Katrina recovery efforts continue. However before traders get too excited about the dollar rally, the latest move could be nothing more than the calm before the storm because we have yet to see any economic data that would reflect the impact of Hurricane Katrina. Once that filters in, another bout of dollar weakness would not be surprising. There is little chance that spending, sentiment and economic activity could continue at an accelerating pace with oil prices at such elevated levels and the nation struggling with more than a million displaced people in the Gulf States. The government has already shared their forecast of tougher times ahead. US Treasury Secretary Snow said yesterday that the combination of higher energy prices, job losses and closed businesses could shave as much as 0.5% off of GDP growth in the quarters ahead. The government also raised their winter energy forecasts to $70 a barrel and announced that up to 400,00 jobs could be lost as a result of Hurricane Katrina. This begs to question whether we could see a pause in the Fed tightening cycle. We answered this question already yesterday when we forecasted a quarter point rate hike later this month but suggested that the November decision was far more uncertain. The question that we are tackling now is whether a potential November pause could be a mid-cycle pause with a resumption of tightening in early 2006. It is undeniable that inflation is on the rise. Just today, we saw unit labor costs, a measure closely followed by the Fed jump 2.5% in second quarter compared to the initially reported 1.3% rise. This upward surprise definitely does not help the Fed in making what is already a difficult decision. If inflation does continue to rise not only on a headline level, but also on a core level, the Fed may have no choice but to continue raising rates later on, even if they do pause momentarily. Meanwhile the same report indicted that productivity growth took a sharp dive as well, rising only 1.8% compared to 2.2% the previous month. Even though some critics are saying that this weakness may cause the Fed to reconsider a now familiar line in the FOMC statement that says “robust underlying growth in productivity, is providing ongoing support to economic activity,” we doubt that the Fed has enough information about the impact of the recent setback to eliminate the sentence later this month. It has been a staple on FOMC statements since since September 2003.

Euro - The Euro is weaker for yet another day but economic data out of the region continues to show resilience to the rise in oil prices. German industrial production rose 1.2% in the month of July compared to the market’s expectations calling for a 0.3% slide. Although this number is fairly volatile, taken together with yesterday’s strong factory orders number and we see that economic activity was expectionally strong. However, these numbers are for the month of July. Right now, we are in September, which means that the current state of the economy could be very different. In our opinion, the future health of the Eurozone economy is largely dependent upon the value of the Euro as well as oil prices. If the Euro rises but oil prices stay steady at current levels, the region’s growth could dissipate.

British Pound – There were some interesting findings in the U.K. economy today as traders digested both the HBOS Plc housing report and National Institute for Economic and Social Research’s estimates for growth domestic product on the eve of the Bank of England policy meeting. According to the country’s biggest mortgage provider, housing prices actually rose by 1.6% the month of August, the largest since September of 2004. However, the report leaves some skeptical, as the recent figure is currently at odds with previous housing data provided by Nationwide, the U.K.’s largest building society, last week. According to the Nationwide report, housing valuations actually dipped 0.2%. As a result, rising notions that the housing market may have seemed to stabilized rather than pickup have been sparked, lending to speculation that policy makers may now have enough evidence for a pass on another repo rate cut this time around. Additionally contributing to the theory were GDP estimates furnished by NIESR. According to the leading think-tank, the domestic economy looks to be advancing in line with trend and may not need further cuts to bolster growth. Europe’s second largest economy grew by 0.5% in the past three months after facing a prior slowdown. This is also contradictory according to results by the statistics office released yesterday that stated that industrial production was still off, declining 0.3% in the month.

Japanese Yen – To the delight of Yen bears, today’s Japanese economic data remained indicative of the slow pace at which the world’s second largest economy is growing. According to the Cabinet Office, the economy’s index of leading indicators fell to a reading of 50 from the previous month’s 63.6 figure, slightly better than the consensus 44.4. Compiled using data from a number of factors including new job offers, consumer sentiment and Tokyo share prices, the figure looked to be propped higher by rising employment figures and increasing equity share valuations while being offset by lower consumer sentiment. Lending to notions of declining consumer sentiment looked to be retail gasoline prices that are near a 14-year high. The nation’s refiners including Nippon Oil and Idemitsu Kosan raised wholesale gasoline prices due to surging underlying crude oil prices for the past week. Now with higher gasoline to pay, consumers may be even more reluctant to spend in tandem with the recent pro-tax legislation, adversely affecting the overall economy. However, this notion remains questionable when compared to the most recent consumer confidence data that actually rose for the third time in four months. As a result, yen bulls may have to continue in their pursuit for dramatically uplifting data that would confirm a strong turnaround in the Japanese economy. Subsequently, the coincident index was released dramatically lower than expected at a reading of 22.2 versus a 100 reading from the previous period. Although dramatic, the figure garnered little attention as it remains to be a compendium of previous releases and thus is somewhat predictable.


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