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Friday September 23, 2005 - 21:02:21 GMT

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Rita Downgraded, China Revalues against Yen and Euro – All Dollar Positive

DailyFX Fundamental 09-23-05

By Kathy Lien, Chief Strategist of

· Rita Downgraded, China Revalues against Yen and Euro – All Dollar Positive
· Expect Changes to G7 Statement this Evening
· Fed Speeches Dominate US Calendar in the Beginning of Next Week

US Dollar
The dollar is stronger yet again as we see another downgrade for Hurricane Rita. Yesterday, Rita was downgraded from a Category 5 storm to a Category 4 and today it was downgraded once again to a Category 3. Tensions are beginning to subside in the markets along with oil prices, which are down more than 2 dollars today. Yet the market is still holding its breath just to be extra sure since Katrina made landfall as a Category 4 and was still able to do extensive damage. Rita is weak, but is pretty much aiming for the same areas that have already been hit by Katrina, which may be a double blow to the refineries in the region. Also, the G7 meeting is happening at the moment and a statement is expected later this evening. It should be no coincidence that China took another step towards more currency flexibility today by widening its trading band for the Yuan against non-dollar currencies from 1.5% to 3% at this time. This should pave the way for the changes to the G7 statement due tonight, which has remained essentially unchanged since February 2004. Their tone on currency flexibility which was aimed at China should be much softer this time around and the group is most also expected to acknowledge the steps that China has already taken, while at the same time suggesting that more revaluation may still be needed. Energy prices are also expected to have been a big topic of discussion. French Finance Minister Thierry Breton wants to pressure oil companies and governments to expand investment and production in oil refining. A sharp rise in oil prices has dampened the global economy; the IMF projects that world economic growth will register at 4.3 percent this year and next, slower than the 5.1 percent increase in 2004 on higher oil prices. The fund sees oil prices as a growing threat to the global economy. Although both the G7 communiqué and Rita (which is expected to make landfall on Saturday) could set the tone for trading next week, if both pass over without any major lasting impact, we should have a week where we could find the dollar in a tug of war between data and Fed comments. Economic data is expected to get progressively softer in the weeks to come, but with seven Fed speeches on the calendar from Monday to Wednesday, we could very well see Fed Presidents and even Greenspan try to soften the blow by downplaying the significance of the softer data.

The Euro sold off over 120 pips today on broad dollar strength. The German import price index checked in higher than expected for August at 0.9 percent month over month compared to the 0.7 percent consensus. Meanwhile, Italian retail sales figures for July disappointed, down 0.3 percent when analysts expected a 0.2 percent gain, highlighting a major problem in the European economy. French wages rose 0.6 percent during the second quarter compared to 0.9 percent in the first quarter. On the political front, at the first meeting since this weekend’s deadlocked election, both Chancellor Schröder and conservative contender Angela Merkel refused to relinquish claims to the Chancellor post. They agreed to meet again on Wednesday, perhaps showing both sides are willing to discuss the possibility of a grand coalition.

British Pound
The beaten down pound found no respite today as it finally broke decisively through both the 1.7900 and 1.7800 levels to settle at 1.7760 at the end of NY trading today. This a low not seen since August 8th and was triggered by traders reacting to China’s trading band announcement. Without any economic news on the table, traders were also left to worry about the prospect of a disappearance of the pound’s interest rate advantage within the next few months. In their latest statement, the FOMC seemed rather optimistic despite the possibly disheartening effects of Katrina leaving many market participants with the belief that there could be two more quarter point hikes before the end of the year. Even the Bank of England monetary policy committee acknowledged in the minutes of their September 8th decision that Katrina’s “effects might be relatively small and short-lived”. This puts the pound in a predicament – with two more rate hikes, the Fed rate could reach 4.25% which is exactly where the BoE rate will be if there is another UK rate cut. If this turns out to be the case, the pound will probably stay under pressure until the lower borrowing rates finally turn into respectable recoveries in consumer spending and economic growth. We will get our first chance to see what the central bank thinks following the release of their Quarterly Bulletin on Monday.

Japanese Yen
The Japanese Yen has sold off strongly against the dollar, lifting the USDJPY currency pair to the highest level in 2 months following China’s latest revaluation announcement. Although the currency pair initially spiked higher on optimism that China is making another move, it eventually reversed course as the market realized what the wider trading band really meant for the yen. Due to the volatility in the Euro and Yen, some people are arguing that China has found it difficult to actively keep the currency in a 1.5% trading band. More likely though, this well-timed move is probably just another step towards China’s goal of further financial market and currency flexibility. This would mean in the near term that China would have a reduced demand for Japanese and Eurozone bonds but over the longer term, China has also announced that they do not believe that US Treasuries is a good investment, which suggests that another announcement pertaining to dollar could come in the weeks or even months ahead.


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