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Monday October 17, 2005 - 21:05:41 GMT
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Forex: Dollar Rallies on Speculation that Fed will Aggressively Tackle Inflation

DailyFX Fundamentals 10-17-05

· Dollar Rallies on Speculation that Fed will Aggressively Tackle Inflation
· German ZEW Survey Expected to Rebound
· Pound Slides as Deputy Governor Long Resigns

US Dollar

The US dollar has gained strength in a relatively quiet day as the market prepares for tomorrow’s heavy dose of global economic data. Here in the US, we are expecting reports from all facets of the US economy including inflation, foreign appetite for US securities and the housing sector. Inflation will remain on the top of everyone’s list of things to watch as producer prices are expected to grow just as fast as consumer prices, if not faster. It is hardly a secret that producers have borne the brunt of higher input prices over the past few months as they watch their margins continue to get squeezed. Higher inflation seems to be the market’s only focus these days as the futures market has now fully priced in at least 2 more rate hikes to 4.25% with a more than 50% likelihood of another rate hike on January 31st to 4.50%. After last Friday’s sharp surge in consumer prices, we saw analysts from the leading investment banks step out to tout the possibility of 5% rates. Although we think that this is a bit far fetched given the dark clouds hanging over nearly every piece of data we have seen over the past few weeks, it does confirm that the dollar will continue to benefit from higher interest rates and hold onto its title as the favorite carry trade currency to go long in 2005. With no less than ten Fed speeches this week, nine of who are voters this year or next, we doubt that the Fed will let the market forget about how concerned they are for inflation. Therefore the risk for the dollar this week appears to be on the upside, but we will first have to see how the results of tomorrow’s TIC report of foreign purchases of US securities fares in the month of August. So far, foreign inflows are expected to reach $60B, which is less than the previous month, but just about meets the funding needs for the same month’s trade deficit. If the dollar is lucky enough, as it has been over the past few weeks, the market could shrug off a weak report like they did this morning and proceed on with its rally. The Empire Statement manufacturing survey shrank from a downwardly revised 15.6 to 12.1. The dollar barely budged even though the rise was primarily led by the growth in the prices paid component. The employment component as well as the outlook component both softened.

Euro

Over the past few weeks, the ECB has been spending a lot of time clarifying their stance. As a central bank that traditionally likes to prepare the market for any significant changes to monetary policy, the ECB is doing a good job of confirming that interest rates are appropriate and if they were forced to make a move that it would certainly be to the upside at the moment. ECB members Trichet, Issing and Weber all reaffirmed the central bank’s hawkish bias. The highlight of the week in terms of European economic data will be tomorrow’s ZEW survey. The index of economic sentiment is expected to rebound as the slump that we saw back in September was primarily attributed to the uncertainty surrounding the German elections. Consumer prices in the region are also expected to tick higher, validating the ECB’s call for more vigilance when it comes to dealing with inflation. The inflation rate is now solidly above the central bank’s 2% pain threshold so they have no choice but to stay vigilant.

British Pound

The British pound has taken a nosedive as Andrew Long, Deputy Governor of the Bank of England bows out of his role to join the private sector. Long will be replaced by Sir John Gieve, the Permanent Secretary of the home office. As a well-known hawk, Long is said to have played a big role in the central bank's more conservative monetary easing policy and more aggressive tightening policy. His departure is expected to make the Bank of England’s monetary policy committee more apt to lower rates going forward. The inexperience of John Gieve could make him more compelled to follow the leaders for at least the next few meetings before we can get a sense of what his true bias may be. As reported in our Morning Brief, house prices rose by 0.5% according to the October report, which was the biggest jump in 6 months and the first improvement in 5. However, as has been the recent trend, the outlook for interest rates dominated this morning’s price action.

Japanese Yen

The Japanese Yen shot higher today with a test of 115 now seeming inevitable especially since we are pennies away from that at this moment. The minutes from the September 7-8 Bank of Japan monetary policy meeting indicated that the decision to keep the liquidity target unchanged was 7-2 from 8-1 at the last meeting. The BoJ is gradually moving towards an eventual departure from their zero interest rate policy, although this will not be something that we see until next year at the earliest. Meanwhile at the G20 summit in Beijing, the Chinese Premier pledged to ECB President Trichet that the Yuan will become more flexible. Although no timeframe or size of further revaluation was discussed, it validates the market’s belief that China’s job is far from over. Of course, we believe that China will look for another politically opportune moment to make their next move and though it will be a minor step it will be politically significant.

 

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