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Forex: Dollar Rallies after Hawkish Comments from Bernanke

DailyFX Fundamentals 06-05-06

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

• Dollar Rallies as Hawkish Comments from Bernanke Boost Rate Hike Expectations from 48% to 76%
• 25 More Likely than 50 From the ECB
• Pound Suffers as BoE Remains the Laggard

US Dollar

When Ben Bernanke was nominated to take over Greenspan’s job as Federal Reserve Chairman, the market had hoped that the clear speaking economist would give more transparency and stability to monetary policy. However, in the months since he has taken the job, the market is probably more confused than ever. The weak non-farm payrolls report on Friday had many traders and analysts convinced that there would be a pause in June. However, comments by Bernanke this afternoon in Washington have everyone once again rethinking the possible scenarios. To the surprise of anyone listening to the speech, Bernanke was fairly hawkish, focusing primarily on the buildup of inflation pressures and how they must be “vigilant,” a word the European Central bank used when they first embarked on their tightening policy. He downplayed the recent weakness in economic data by saying that we are entering into a period of transition and that the recent moderation in growth is “anticipated.” The harsh words by Bernanke bring back the possibility of a June rate hike. In fact, expectations for a quarter point rise at the end of the month has shot up from less than 50 percent (48 percent to be exact) before Bernanke started to speak to a whopping 76 percent. When a central banker is as hawkish as Bernanke and stresses the need to prevent against the increases in energy and commodity prices being permanently embedded in core inflation, we must listen. Even though this is simply delaying the inevitable end to interest rate hikes, it will certain give the dollar some breathing room. Service sector ISM dropped from 63.0 to 60.1 in May, which was slightly stronger than expected and still represents solid growth. The prices paid component jumped from 70.5 to 77.5, validating Bernanke’s fears of inflation pressures. For the remainder of the week, the US calendar is extremely light with the ECB monetary policy meeting the biggest event over the next few days. Bernanke’s comments have injected a bit of dollar bullishness going into the meeting, but with a lot of European economic data due for release from now until Thursday, expectations of whether the central bank will move by 25 or 50 basis points could either exacerbate or alleviate the Fed’s more hawkish stance.

Euro

The Euro has come under selling pressure after Bernanke’s comments this afternoon. ECB President Trichet, who spoke after Bernanke told the market explicitly that he would not be commenting on monetary policy given the proximity of their interest rate announcement. He was pleased that growth was moving towards their target and said that the Eurozone needed to work on their structural problems. Some Euro selling was seen after a closely followed newsletter for hedge funds predicted that the ECB would raise rates by only 25 basis points instead of 50. Even though some proponents have been calling for a half point hike, a quarter point move is really the more likely scenario. By raising rates by only a quarter point, the ECB leaves themselves ammunition for the months ahead. By raising 50bp in one meeting when global growth is at risk of decelerating could exacerbate the rise in the Euro and the sell-off in the financial markets, which would have negative repercussion for the region’s economy. Therefore it may be far more logical for the central bank to give themselves wiggle room by raising only a quarter point on Thursday and then remain hawkish, but reiterate that any future rate hikes will continue to be data dependent.

British Pound

The divergence between what is going on in the Eurozone and the UK is becoming increasingly apparent. The British pound saw a steep 160 pip slide today in contrast to the Euro, which only sold off by 75 points. Service sector growth in the UK slowed from 59.7 to 59.2, which was disappointing, but the retracement was slightly less than expected. What traders are weighing more this week is what the ECB is doing versus what the Bank of England is not doing. The ECB is clearly on the path of higher interest rates while the BoE is still in limbo. The recently conflicting economic reports make the decision even more difficult which suggests that the central bank will not be delivering any major changes soon. This divergence has fueled sharp gains for EUR/GBP and exacerbated losses while limiting gains for the GBP/USD.

Japanese Yen

The Japanese Yen is weaker against most of the majors today as Bank of Japan’s Muto confirmed that the central bank is in no rush to raise interest rates. The only piece of Japanese economic data released last night was capital spending which came in much stronger than expected. Spending rose 13.9 percent in the first quarter, which compares to the 7 percent consensus forecast. It is undeniable that the economy is improving, but so far, it hasn’t been enough to give Japanese officials the confidence to move on rates. Any potential moves will probably be delayed until the fourth quarter when the LDP changes leadership. At that time, the economy may also be on a sounder footing which could be a better backdrop for the inevitable interest rate hike.

 

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