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Tuesday March 21, 2006 - 22:03:07 GMT

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Forex: Dollar Rallies but is Inflation Really Here to Stay?

DailyFX Fundamentals 03-21-06

By Kathy Lien, Chief Strategist of

• Dollar Rallies but is Inflation Really Here to Stay?
• More Reasons for the ECB to Raise Rates
• Less Reason for UK to Cut Rates Again this Year

US Dollar

For the second day in a row, the US dollar recuperated last week’s losses. Yesterday it was the high yielders that lost the most ground against the greenback, but today, it is the majors such as the Euro and the Japanese Yen that experienced the biggest drop. In his speech to the NY economics club last night, Federal Reserve Chairman Ben Bernanke said that short term rates have the possibility of moving higher and in his view, the current shape of the yield curve does not signal an impending slowdown. Even though he did not venture far from his usual comments, the US dollar gradually lost strength throughout the Asian and European trading sessions. The larger part of today’s move however was driven by this morning’s inflation report. Even though headline producer prices fell a whopping 1.4 percent, the biggest drop in close to three years, core prices rose a more than expected 0.3 percent. This goes to show that even though energy prices have been falling, taking the pressure off food and fuel costs, second round inflation effects are clearly emerging. Despite the latest dollar rally, it is still very likely that we saw a major turn in the markets last week. Today’s inflation report gives the Federal Reserve a solid reason to raise rates at the end of the month, but should weaker headline inflation filter into core prices over the next few months, the case for 5 and 5.25 percent rates will weaken. Consumer prices released last week were far from encouraging with only a modest 0.1 percent rise for both headline and core prices. This confirms that inflation pressures could very well subside, which would suggest that the dollar’s clear bull trend throughout 2005 is finally coming to an end.


Unsurprisingly, stronger Eurozone economic data failed to lift the Euro. Consumer spending in France jumped 1.8 percent in the month of February while the current account deficit shrank to a much more than expected EUR3.2 billion. The strongest pace of spending since October 2004 eases fears that France is lagging far behind Germany. However, with strikes related to labor law reforms and elections in Italy, the region’s political landscape could get messy. With the market having completely discounted another rate hike from the European Central Bank, politics could easily trump economics. A clear sign that the market is already shrugging off the central bank’s stance is the lack of strength in the Euro despite hawkish comments from ECB President Trichet, Chief Economist Issing and ECB Liikanen who is the latest central banker to add that he too, views monetary policy as too accommodative. Over in Switzerland, inflation pressures continue to give the Swiss National Bank reason to raise interest rates. In February, producer and import prices rose a more than expected 0.3 percent on a monthly basis and a 1.6 percent on a year over year basis.

British Pound

Even though the British pound managed to hold onto its gains yesterday, it was not able to show the same resilience today. US dollar strength prevailed despite encouraging inflation figures across the pound. Consumer prices in the UK rose 0.3 percent last month after dropping 0.5 percent in January. Core prices rose a more than expected 1.4 percent on an annualized basis, up from 1.3 percent the month prior. By now it should be clear to our readers that UK data continues to support the Bank of England’s on hold stance. If anything, it gives the central bank an even better reason to stand pat while at the same time convincing some pessimists that things really aren’t all that bad. However the dollar tends to cloud the market’s true perception, so we turn to EUR/GBP to see where sentiment really stands. The price action indicates that over the past two days, the market has turned more optimistic on the pound against the Euro. Tomorrow we are expecting the minutes from the latest Bank of England meeting which should give us more insight into where the members of the monetary policy committee stand. Should the one dissenting member shift to neutral, we could see a strong recovery in the British pound.

Japanese Yen

After delivering sharp moves to the downside last week, we are seeing sharp moves to the upside this week. With the Japanese markets closed for the Vernal Equinox Day, there seemed to be no buyers left in the market, as the Japanese Yen fell 0.8 percent against the dollar. The quick reversal that we saw yesterday in USD/JPY should tell traders that even though we haven’t heard from the Bank of Japan lately on currency movements, the fear that they stand ready to act like they did throughout 2002 and 2004 is very real. Unlike Europe, the country’s central bank officials in Japan have made it clear that even though they have dropped quantitative easing and want to see short term rates higher, they still do not want it to be that much higher than zero. Meanwhile even though the dollar shows signs of having made a big trend reversal last week, USD/JPY’s ability to hold that reversal will probably be weaker than the EUR/USD’s ability. Being short USD/JPY requires paying far more interest than being short the dollar against the Euro. On a hedge fund level, this difference is substantial and could make EUR/USD a much more attractive short dollar trade than USD/JPY in the future.


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