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Monday October 3, 2005 - 20:46:46 GMT
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Forex: Dollar Surges Ahead as Fed Rate Hike Expectations Rise

DailyFX Fundamentals 10-03-05

By Kathy Lien, Chief Strategist of www.dailyfx.com

· Dollar Surges Ahead as Fed Rate Hike Expectations Rise
· Euro Continues to Fall Despite Possible Resolution to German Political Stalemate
· Tankan Misses Expectations, Contributing to Slide in Japanese Yen

US Dollar

The dollar’s unstoppable rally continued today, blasting past 1.20 and then spending most of the US session testing the resolve of euro bulls trying to defend the 1.1900 level. To the surprise of many, most of the September data that we have seen thus far suggests that Hurricane Katrina has had a limited impact on the economy. The national manufacturing index accelerated from 53.6 in August to 59.4 in September, which follows Friday’s advance in the Chicago PMI survey. Like the Chicago report, the improvement in the national index was broad based, with acceleration even in the employment component, which means that it would be difficult for anyone to try to pinpoint some sort of weakness in the report. Additionally, we also saw a record high in construction spending for the month of August. Even though the number was pre-Katrina, with all of the rebuilding efforts following the hurricane, construction spending could be even higher in the month of September. Right now, momentum and rate hike expectations is behind the dollar’s rally. Dollar bears are questioning their positioning harder with each passing day while dollar bulls continue to charge on forward. Throughout last week, Federal Reserve officials have held onto their hawkish views and spent most of their time downplaying the significance of Katrina and it seems that the market really believes them. Fed fund futures have been moving around quite a bit lately and are currently pricing in a high probability of quarter point moves in both November and December. In fact, there is even a growing possibility for a move to 4.50% early next year. Of course, these expectations can change just as rapidly later on as they have over the past few weeks so it will be interesting to see how the market reacts to this Friday’s non-farm payrolls release.

Euro

The euro began taking another nosedive in early trading last night on fears that Turkey’s bid to join the European Union may face some tough hurdles at the emergency meeting this weekend. The membership talks avoided an early failure only a few hours ago with many EU ministers clinging to their seats in anticipation of news about whether Austria would really block Turkey’s proposals. After more than 24 hours of negotiations, there finally seems to be some hope with Turkey’s foreign minister flying in to attend the meeting. Over in Germany, there also seems to be some progress on the German political stalemate. This weekend in Dresden, Merkel’s party won another seat in Parliament. For the first time since the elections, Schroder is also showing signs that he may be willing to give up his claim to Chancellorship. In a TV interview, Schroder said, “I will not stand in the way of anything that would lead to a continuation of the reform processes that I started, and a stable government in Germany.” He added, “This is not about my claim, and absolutely not about me personally.” So with potentially 2 down and 1 left to go (no new news out of Italy), there still could be light at the end of the tunnel for the Euro. Economic data also seems supportive of a relief rally at some point. The Eurozone manufacturing survey leaped from 50.4 to 51.7 with improvements seen in Italy, France and Germany.

British Pound

In the UK, manufacturing seems to have picked up following recent improvements in economic data over the past several weeks for Europe’s second largest economy. According to the CIPS/RBS Purchasing Managers’ Index, activity rose to a 51.5 print from last month’s 50.3 reading. Above the 50 expansionary level, this is the fastest pace of growth in six months as new orders rose on higher global demand. Notably, manufacturers, unable to pass on higher energy costs, reported lofty price increases. Suggestive of increasing inflation, Bank of England policy makers will be sure to take note of the latter when they convene this week for another interest rate decision. This time around predicting the outcome should be considerably easier with majority sentiment leaning towards another “no-action” decision as economic conditions improve thanks to bottoming housing data along with a suggestive pickup in manufacturing. However, in light of still depressed domestic demand, market players will be readily anticipating tangible industrial and manufacturing data later on in the week in confirming any speculative reversals. Any up ticks in the data will certainly prove to policy makers that the current neutral policy is sufficient in bringing the region out of the doldrums.

Japanese Yen

Large manufacturer optimism remained buoyant in the month, although missing consensus expectations today. The September Tankan survey showed an increased reading for the second consecutive quarter from a positive 18 in the previous month to the current rise to 19. However, traders became wary as the reading fell below consensus estimates of a 20 figure, leaving many to contemplate any further gains on the diffusion index going forward. In addition, government releases also printed increases in labor cash earnings, which leads one to believe further earning potential on the part of the household. Although the two have been cited as major reasons why the domestic currency took a beating today, it is suggestive that comments from central bank Governor Toshihiko Fukui had ultimately led the charge for yen bears. Contradicting comments made last week by subsequent officials that forecasted an end to deflationary conditions in the upcoming six months, Fukui confirmed no rush to shift to a tightening policy. These recent comments are inline with previous requirements that a minimum of two consecutive monthly pickups in consumer prices would be needed. However, further indications of expansion would also be required in conjunction to viably shift central bank ideology.

 

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