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Wednesday June 7, 2006 - 20:49:01 GMT
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Forex: ECB – 50bp Unlikely

DailyFX Fundamentals 06-07-06

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

• ECB – 50bp Unlikely
• Fed Officials Unanimously Hawkish Boosting Dollar
• Pound Losses Limited on More Acquisition News

US Dollar

For the third day in a row, the US dollar has outperformed the other major currencies. The market is continuing to readjust its expectations for the monetary policy meeting at the end of this month. The Federal Reserve remains primarily hawkish with a chorus of Federal Reserve Presidents backing up Chairman Ben Bernanke’s recent concerns for the buildup in inflation pressures. In the past 48 hours, we have heard from Bies, Livingston, Poole and Guynn. Of the four, only Bies is a voting member of the FOMC. However, the solidarity within the Federal Reserve comes at a critical time and tells us that barring any major unforeseen circumstance, they will be raising interest rates by a quarter of a point in June. Beyond that, it is up in the air. In the few months that Bernanke has been the Fed Chairman, he has already proven to be rather wishy washy with the messages that he has been sending out to the market. Liz Rappaport of Marketwatch published a breakdown of recent comments by “Bouncing Ben.” According to her report, in November at the Senate Banking Committee, Ben Bernake was hawkish and tried to dispel any dovish perception. At the semi annual report to Congress in February and in the March 28 FOMC statement, his tone was mixed to hawkish. However, in the April 18 minutes for the March meeting and the April 27 Joint Economic Committee testimony, he was surprisingly dovish, bringing up for the very first time the possibility of a pause in the Fed cycle which caused a major wave of selling in the US dollar. Then at the White House Correspondence dinner, Bernanke told CNBC reporter Maria Bartiromo that the market misinterpreted his comments and from then on, he started to be extremely hawkish. So in the course of one and a half months, Bernanke has flipped from being mildly dovish to extremely hawkish. It is clear that the Fed is placing far greater weight on inflation risks than economic risks, but this may be a dangerous game that they are playing. We already saw extremely weak payroll numbers and if the Federal Reserve continues to tighten monetary policy, economic growth could suffer even more. This means that even though the Fed has injected some dollar optimism into the market, further losses could remain limited.

Euro

The market’s main focus tomorrow will be the European Central bank’s interest rate decision. For weeks now, there has been rampant speculation on how large of an interest rate hike the ECB will be delivering. The consensus is for a quarter point hike but with economic data extremely positive and central bank members extremely hawkish, there are some who expect a half point hike tomorrow. We think that this is unlikely for a variety of reasons. First, even though the ECB is not currently concerned with the value of the Euro, they could be if the currency trades above 1.30. Austrian Finance Minister Grasser says that as long as the Euro stays between 1.20 and 1.30, they are comfortable. A half point hike would catch most of the market by surprise and easily shoot the EUR/USD above 1.30, into what is probably the pain threshold for most Eurozone officials. Secondly, at their meeting yesterday, finance ministers have already pleaded with the central bank to keep any interest rate hikes at a minimum. The ECB will probably err on the side of flexibility by being more conservative with rate hikes in the near term, raising rates by only 25bp and saving the other 25bp as ammunition for the future. If needed the ECB could easily opt to deliver an inter-meeting hike to ward off any unexpected inflationary pressures. The central bank will probably remain hawkish and they have good reason to be with a majority of economic data continuing to surprise to the upside. This morning, retail sales and retail PMI all increased strongly highlighting the continual recovery in the region’s economy.

British Pound

US dollar strength has pushed the British pound lower as the market looks ahead to no changes from the Bank of England for the tenth consecutive month. Disappointments in the UK come at a time when the outlook for its neighbor, the Eurozone is becoming more promising. Tomorrow we are also expecting industrial and manufacturing production for the month of April. Growth is expected to slow from the previous month with annualized growth expected to remain flat. The only thing holding up the British pound has been mergers and acquisitions. Switzerland based Novartis made a GBP305 million bid for Britain’s NeuTec Pharma today while not too long ago, Spain’s Grupo Ferrovial announced a GBP10.3 billion takeover of airports in the UK. The free market principles of the UK is making the country’s companies more attractive than US companies where potential bids have been met with push backs from the US government. Unless the US relaxes its protectionism policies, this is a trend that could very well continue, one that is negative for the US dollar.

Japanese Yen

The Japanese Yen is slightly weaker against the US dollar today as the stock market takes a big tumble. Economic data continues to be positive with the leading economic index at 50 percent, in line with expectations and the coincident index increasing to 77.8 percent, slightly above expectations. Machine tool orders were also strong, rising by 14.8 percent compared to 1.4 percent the previous month. A report by the Chinese Economic Research and Advisory Program has recommended that China continue to widen its trading ban and scrap tax breaks for foreign investors to help reduce the country’s capital account surplus. More flexibility in China’s currency is certainly the way to go, but as what has always been the mode of operation in China, the government will continue to move on their terms. There is minimal data due from Japan for the rest of the week which means that price action will continue to be dictated by Euro and Yen movements.

 

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