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Wednesday July 7, 2004 - 20:35:01 GMT -

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Bank of England Expected To Keep Rates At 4.50%

DailyFX Fundamentals 07-07-04

· Dollar Tanks As Gold Rallies By Largest Amount in 13 Months
· S&P Cuts Italy’s Credit Rating
· Bank of England Expected To Keep Rates At 4.50%


After a brief period of consolidation, we are finally seeing the euro resume its near term upward trend. Benefiting primarily from dollar weakness, the stop induced rally in the EURUSD was extended following stronger German factory orders. The market had initially expected factory orders to remain unchanged, however rising exports has helped boost factory orders by 1.6% in May. More specifically, according to the German government, orders from abroad increased 4.1%, while domestic orders fell 0.6%. Consumer consumption in Germany remains weak, as the country remains dependent on an export-led recovery. Meanwhile, rating agency Standard & Poor’s announced that it downgraded Italy’s long-term debt rating from AA to AA- because of its deteriorating budget deficit. S&P said that "Italy's central government cash deficits have risen significantly in 2004, and further widening can be expected in 2005 if ambitious planned tax cuts of around €12bn (0.9 per cent of gross domestic product) are implemented.” The decision resulted in a muted reaction in the currency markets since it was generally expected after S&P put Italy on credit watch in January 2003.


Dollar weakness remains the persistent theme in the market today as traders readjust positioning and economists revise their growth estimates lower. Gold has incurred its largest gains since May 2003. Gold and the dollar tend to trade inversely – part of today’s gains in gold can be attributed to dollar weakness, however, Russia also reduced their reserve requirements for banks to settle the situation in the banking sector and to avert a banking crisis, which boosted the metal’s appeal as a safe haven. There are a number of interesting developments in Russia that merits observation – liquidity issues are becoming increasingly concerning in the banking sector. Meanwhile in the US, mortgage applications increased 19.5% last week, which is the biggest rise in three months. The big gains came on the heels of a sharp drop in mortgage rates, which sparked a rush of refinancing and home purchases as people tried to lock in rates before the Federal Reserve steps up their tightening cycle.


With the market favoring high yield currencies, the British pound has garnered enough momentum to break above the psychologically important 1.8500-level. As we mentioned yesterday, the Bank of England is scheduled to announce their decision on monetary policy tomorrow. The market expects the central bank to keep rates on hold at 4.50%, after raising rates back-to-back in May and June. There is a general consensus that the next rate hike will not come until August. As indicated by BoE Governor Mervyn King last Wednesday, house prices should continue to be a talking point and critical concern at today’s two day monetary policy meeting. King said that house prices are “very important “ to the central bank’s interest rate decisions. Over the past year, the BoE has been very proactive in attempting to prevent a sudden burst of the housing market bubble. Data since the last monetary policy meeting has been supportive of a strengthening UK economy. The December Short Sterling futures contracts are currently pricing in an implied yield of 5.21%.


The dollar rallied 1% against the yen today following yesterday’s report in the Nihon Keizai Shimbun stating that the “Cabinet Office intends to raise its overall economic assessment in its July monthly report for the first time in six months amid growing signs that improvements in the corporate sector are spilling over into the household sector.” Japan’s Chief Cabinet Secretary Hosoda was also making optimistic comments about the Japanese economy at his daily press conference in Tokyo. However, further losses should be limited on the back of elevated oil prices and ahead of Sunday’s Upper House elections. Should Prime Minister Koizumi and his LDP party fail to secure the 51 plus seats needed to solidify Koizumi’s support base, the Nikkei and the yen could be punished as it raises concerns about structural reform. Tomorrow, we are expecting Japanese machinery orders – the data set is fairly volatile. The underlying trend should remain strong, but orders are expected to retrace after the 11.8% gain in April.


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