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Tuesday October 18, 2005 - 21:00:06 GMT

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Forex: Talk of 5.5% Neutral Rates Pushes Dollar Higher

DailyFX Fundamentals 10-18-05

By Kathy Lien, Chief Strategist of

· Talk of 5.5% Neutral Rates Pushes Dollar Higher
· Pound Slide Limited as Housing Market Shows Signs of Bottoming
· Japanese Officials Have No Plans To Stop Yen’s Slide

US Dollar

With both momentum and economic fundamentals on its side, dollar bulls had the confidence to take yet another stab at its 3 month high against the euro. As we warned yesterday, surging inflation especially on the producer price level will give the Fed a good reason to pump up the need for higher interest rates, which is the primary driver of dollar strength these days. Producer prices surged 1.9% on a monthly basis and a whopping 6.9% on an annualized basis. Even though the rise in the ex food and energy component was far more tempered on a monthly basis, the annualized increase was still a respectable 2.6%. This has given the Fed even more ammo to talk up interest rates – Fed President Yellen, who is a non-voter threw out some numbers today. She said that the “neutral rate” that everyone seems to believe that the Fed is aiming for is anywhere between 3.5%-5.5%. This is the first time that the market has even considered the possibility of 5.5% rates. The 5% level that the experts have been parading around already seemed a bit far-fetched, let alone 5.5%. If 5.5% rates is a really a possibility, then it’s the market that is behind the curve and not the Fed. Either way, the trajectory for rates is higher and for as long as the market thinks that rates are going up, so will the dollar. However we continue to warn that the higher rates go, the bigger the risk to the housing market, US growth and consumer spending. Higher interest rates mean not only higher mortgage payments, but also higher credit card payments, and it is already a known fact that US consumers have a tremendous amount of credit card debt. It also doesn’t help that new rules taking effect at the end of the year will require most consumers to pay 4%, up from 2% of their outstanding balances each month. Yet of course, the markets have yet to consider this a potential risk and chosen to focus more on the short-term factors that are impacting the dollar at the moment. For the time being, the combination of higher interest rates and stronger capital flows is being very supportive of the dollar. Just today, the Treasury reported that foreign purchases of US securities hit $91.3B in August, which is the strongest inflow in 15 months. Increasing appetite for dollar denominated assets were seen across the globe with US citizens even dumping foreign securities to snap up US securities (part of this is of course probably related to the Homeland Investment Act repatriation flows).


Although dollar strength was the primary catalyst for the move lower in the EURUSD, disappointments from Eurozone certainly didn’t help. The ZEW survey of investor confidence increased from 38.6 in September to 39.4 this month, which was about 3 points shy of the market’s forecast. Investors were concerned that the new coalition government will not be able to boost economic growth and will not allow Angela Merkel to deliver on her promised tax cuts and deregulation in order to cut near-record unemployment. Meanwhile German producer prices also increased by a less than expected 0.4% in the month of September, even though this was the strongest pace of growth in over 4 years. The only positive surprise was in the region’s CPI numbers, which came out at 2.6%, or 0.1% higher than the market’s forecast. Yet, even in this report, there were disappointments – core CPI growth remained stagnant. This should do little to change the central bank’s overall stance - with CPI so high and energy prices threatening to have second round effects, the ECB may be forced to tighten monetary policy for the first time since 2000, as early as next year.

British Pound

Mixed data has helped the British pound recuperate most of its gains against the dollar while the Euro remained under pressure. The consumer price index for September was slightly softer than expected, rising .2% from August, and 2.5% yoy. This should not have a significant impact on the central bank’s on-hold stance since it is still the highest rate of growth in at least 8 years. This is also the fourth straight increase with oil prices pulling the rate well above the 2% level. Oil prices still pose a growing threat and we expect the BoE minutes scheduled for release tomorrow to should reflect such sentiment. Meanwhile today’s RICS house price report confirmed the stabilization of the housing market that was suggested by the Rightmove house price survey released yesterday. The house price balance improved to –21 from –25 prompting the group’s chief economist to note that the housing market slowdown may be drawing to an end.

Japanese Yen

The Japanese Yen has fallen 6% against the dollar over the past two months, with prices pushing easily above the 115 barrier. The central bank seems to be taking this in stride, noting that they have no plans to intervene in their currency to halt its decline and in fact do not view it as a “problem.” Why should they? As an export dependent economy, a weak currency helps to boost business for their domestic corporations. The Bank of Japan’s Deputy Governor said today that Japan’s economy has emerged from the softness of early summer and is continuing to recover. He stated that overseas economies are looking to be expanding as well which will push up export demand. This in turn will spur higher profit levels and drive a gradual rise in incomes, which will then help to boost domestic demand. This comes at a time when Japan is finally able to breathe a sigh of relief as growth accelerates and the stock market lingers near its 4 year high. If the weak yen continues to stimulate to the economy, it will not be long before we see Japan’s first interest rate hike. Meanwhile the only two pieces of data out of the Japan overnight was the final leading economic indicators index and machine tool orders. Both pieces of data confirmed the improving conditions in the Land of the Rising Sun.


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