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Thursday May 11, 2006 - 21:11:43 GMT

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Forex: Dollar Unchanged as Fed and Treasury Delay the Inevitable

DailyFX Fundamentals 05-11-06

By Kathy Lien, Chief Strategist of FXCM

• 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

The US dollar continues to sell-off as traders wonder when the weakness will come to an end. The original hope was that retail sales would come in strongly to help the dollar stage a much needed relief rally. This is what European and Asian traders were positioning for as they bought dollars throughout the earlier trading sessions. However once the market saw that consumers did not increase their spending as fast as they did the previous month, they sent the dollar tumbling because they realize that the ramifications for weaker spending are huge. First, it indicates that higher gas prices are really hitting the pocketbooks of consumers. With spending rising only 0.5 percent at a time when job growth is slowing, the possibility for it to hurt even more in the months to come are huge. Consumer spending always plays a major role in growth and if data continues to disappoint, the Fed has the support it needs to take a break from raising rates. At this point, 1.30 in the EUR/USD is simply an arm’s length away. We expect traders to try to test that level especially if the trade figure comes in wider than expected tomorrow. Expectations are not far from January’s all-time high in the deficit. With the market accentuating the negative and minimizing the positive, even if the trade deficit comes in ever so slightly wider than expectations, traders will shoot for 1.30 in the EUR/USD. On the other hand, we would probably need to see a deficit better than -$62B to see a meaningful dollar rally. Meanwhile oil prices are on the rise again, breaking above $73 following fresh geopolitical risks in Nigeria. The pressure on the dollar is based upon real risks these days and not hysteria which means that it can fall even further. At this point, we would need to hear a piece of extremely good news in order to relieve some of the bearish dollar sentiment.


The Euro charged ahead today hitting yet another 12 month high against the dollar. Hawkish comments continue to pour out of the Eurozone, accentuating what could potentially be a big divergence between US and European monetary policy in the second half of the year. ECB member Weber reiterated that low inflation estimates is no reason for them to pause on rate hikes. EU Economic Affairs Commissioner Alumnia also said that he felt the rise in the Euro is not concerning and in fact is helping to relieve some of the pressures of rising oil prices. Finally Dutch central banker Wellink is one of the first government officials to raise the possibility of raising interest rates by 50bp instead of 25. We think that this scenario is unlikely because it would be a very bold step for the central bank since they have never in the history of their monetary policy raised rates by 50bp. In addition, economic growth is not all that great and a larger rate hike could hurt growth significantly. As a relatively cautious central bank, they would probably prefer to spread out their rate hikes to make sure they are not taking any premature measures. GDP growth figures for the first quarter improved from 0.3 percent to 0.6 percent. Interestingly enough, it was Italian growth that saw the big rise and not German growth. German growth came in weaker than expected in the first quarter which is somewhat worrisome since German economic activity has a big sway on overall Eurozone growth and tends to lead that of other countries. Therefore if Germany begins to see slower growth, it may be likely that the others are next. This suggests that despite what European officials are saying, the strong Euro is indeed having a negative impact on the region.

British Pound

The British pound is the day’s best performing currency as it rises strongly against the US dollar, Euro and Japanese Yen. Industrial production figures for the month of March were solid, rising by 0.7 percent compared to the market’s 0.2 percent forecast. Manufacturing production saw a similar rise confirming the market’s notion that the Bank of England has completely dropped their plans to lower interest rates and may actually be contemplating raising interest rates. Things are certainly improving in the UK which means that should economic data continue to strengthen, the Bank of England may indeed step in to close the growing gap between US and UK interest rates. The timing of this is extremely important because if the Fed ends their tightening cycle before the fall and the UK begins to simply talk about raising interest rates, we would have the ingredients for a much stronger rally in the GBP/USD as the interest cycle tips in the pound’s favor.

Japanese Yen

Finally, yen bulls are giving bears a chance to breathe. After at least four consecutive days of strength against all of the majors, the yen has sold off across the board today. Today’s move was triggered by warnings from the Ministry of Finance that it may be necessary for them to intervene in the yen. It is clear that they are becoming uncomfortable with their currency’s sharp rise and they may push for intervention if China does not budge on its exchange rate. 110 has previously been an area of concern for the Japanese so it is no surprise that it would be this time around as well. Meanwhile Japanese corporations are also adding their two cents by saying that they believe the move has run its course. If this is a widespread belief among domestic corporates, it may signal reduced hedging activity by the country’s exporters. If so, there may be less sellers left in the market to take the yen much lower.


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