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Forex: Dollar Unchanged as Fed and Treasury Delay the Inevitable

DailyFX Fundamentals 05-10-06

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

- Dollar Unchanged as Fed and Treasury Delay the Inevitable
- Market Looking for Rate Hike by BoE Later This Year
- Yen Soars as Pressure Remains on China to Revalue

US Dollar

Compared to its open price at the onset of US trading, the EUR/USD is basically unchanged. We actually saw only a mild amount of volatility today despite two major events on the US calendar. The day has been interesting, but the price action less so. Broadly speaking the US dollar is weaker on the day, losing the most ground against the Japanese Yen. If we needed to sum up the day’s activity in one line, we would say that the US is delaying the inevitable. The Federal Reserve is still leaving the door open for more rate hikes, but injected more cautious wording while the US Treasury refrained from naming China as a currency manipulator but toughened up their criticism by calling for more rapid progress. Specifically, the Federal Reserve raised interest rates by a quarter of a point to 5 percent, marking their sixteenth consecutive rate hike. To the shock of the market, the Fed did not tone down the FOMC statement significantly. They repeated that "some further policy firming may yet be needed," but if you read carefully, you will notice that the word “yet” is new. The reason why the dollar gave back all of its initial gains is because the market is divided on what to think feel about this new word. As a sign of hesitancy some say that it means the Fed will raise rates in June but pause in May while others say that a June rate hike is unlikely. We think that the statement still has an air of hawkishness and suggests that even though we are close to end of the tightening cycle, today’s rate hike will probably not be the last. Inflation pressures are still hanging over the economy and traders also tend to forget that a weak dollar also boosts inflation pressures by making imports more expensive, so the Fed is walking on a very fine tightrope. There are still two more CPI readings till the June meeting which means that they opted to postpone the inevitable by giving themselves a chance to first reviews upcoming economic data. For the time being, as the Fed has said in their statement, the extent and timing of further increases will indeed be data dependent. As for the Treasury, it seems that politics outweighed economics. The positive comments on the initiatives and promises made by Chinese President Hu and Premier Wen suggest that the US is trying to play nice and gain political favor with China at this critical time. In line with our introduction of a third scenario in yesterday’s Daily Fundamentals, the US chose the “middle ground” and refrained from branding China as a currency manipulator but toughened up their criticism. They felt that China was making “far little progress” on exchange rates and that the Treasury will “closely monitor” any developments. Should China not deliver any further changes, they could very well still be named in November, especially if geopolitical tensions subside by that time. The muted reaction on today’s reports indicate that the US dollar has become very oversold and there may not be any buyers left in the market. This suggests that if retail sales comes in strongly tomorrow, we see a deep relief rally in the dollar.

Euro

The Euro hit new 12 month highs today largely due to the market’s overall bearish dollar sentiment but hawkish comments from the European Central Bank certainly didn’t hurt. Despite the persistent rise of the Euro, the ECB is showing no signs of backing off from their intention to raise interest rates next month. According to ECB Weber, “more rate hikes are needed, at least 25 basis points.” He says this even though he believes that first quarter GDP growth may have been slightly less than 0.5 percent. The GDP release is due out tomorrow. Overall, the ECB’s clear determination to continue raising rates comes in contrast to the market’s confusion with the Fed’s new “yet” word – which should work to the Euro’s benefit. Meanwhile economic data was mostly positive today with the trade surplus rising in the month of March. An 18.1 percent increase in exports along with a 28.3 percent rise in imports helped to bring the surplus from EUR 13 billion to EUR 14.3 billion. However the current account came in weaker than expected and the seasonally adjusted trade surplus was also lower, which neutralizes the report a bit. Over in France, numbers were decidedly better with stronger growth in both industrial and manufacturing production.

British Pound

Mixed signals from the Bank of England has given the British pound little direction. The sterling rallied against the US dollar but sold off against the Euro. As expected, the BoE did notch higher their inflation forecasts, expecting inflation to remain above 2 percent throughout the next two years. However, they also reduced their growth forecasts for 2007 and 2008. Although the two changes are somewhat conflicting, the Bank of England does believes that the slowdown in growth will be “not much.” The higher inflation pressures already has the market talking about expectations for interest rate hikes over the next year. According to the futures markets, a rate hike could come as early as August with one more down the road. A reinitiating of their tightening cycle should shift the dynamic between the pound and other currencies, especially if economic data continues to improve. The UK trade deficit came in better than expected for the month of March as it narrowed from -GBP 7.04 billion to –GBP 5.45 billion.

Japanese Yen

It is another strong day for the Japanese Yen as it continues to strengthen against the majors. Much of the move has been in anticipation of the US Treasury’s FX report which explains some of the retracement afterwards. Although the market is still speculating that a rate hike could come soon from the Bank of Japan, it is worth noting that the government is fighting them once again. LDP Yamamoto cautioned the BoJ against rushing to raise rates. The public battle between the BoJ and the Japanese government is something that the market has grown very much accustomed to. More often than not, this tension has delayed any intended changes. Japan’s leading indicator index dropped from 90 percent to 60 percent in March with the coincident index also falling from 50 percent to 11.1 percent. This is the first time in six months that the index is below the 50 percent contraction / expansion mark.

 

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