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Wednesday June 28, 2006 - 21:15:11 GMT

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FXCM - Strong and Weak Pairings - Know How to Position Post FOMC

DailyFX Fundamentals 06-28-06

By Kathy Lien, Chief Strategist of

• Strong and Weak Pairings - Know How to Position Post FOMC
• Swiss Franc Soars on Strong Data
• New Zealand Dollar Melts Down on Horrid Trade Balance

US Dollar
Buckle up for an exciting trading day tomorrow. With the market juggling a variety of different scenarios, the one thing that we can be almost certain of is that the Federal Reserve’s monetary policy meeting will cause a breakout in the US dollar. Even though some traders have brought up the possibility of a half point rate hike, we have yet to find one economist that agrees and along with that, we also think that this is one of the least likely scenarios. Another unlikely scenario is for the Fed to raise rates, pause and then raise them again. Instead, the most likely scenario is for a quarter point interest rate hike, but figuring out the size of the hike is not the hard part. The truly difficult part of handicapping tomorrow’s meeting is figuring out what type of changes the Fed will make to their monetary policy statement. The questions are will they loosen the tone on inflation indicating a shift towards neutral, will they keep the statement unchanged, which will force the market to continue to play the guessing game or will they toughen up their stance on preventing inflation from accelerating, which would pave the way for another rate hike in August. Given the recent trend of economic data, the highest probability scenarios are for either an unchanged or a tougher statement – both of which will help the dollar hold onto its recent strength. Core inflation has been stronger than expected for the past three months, allowing the Fed to remain hawkish. Their strong stance has compelled many analysts to upgrade their 2006 US interest rate forecast to 5.75 or even in some cases 6 percent. More importantly than guessing what the Fed will do is knowing how to position in reaction to their announcement. If the Fed remains committed to their tightening cycle, the dollar’s strength will be the most pronounced against the Japanese Yen, British pound and New Zealand dollar. All three currencies have been plagued by either bad economic data or political uncertainty, keeping all three central banks solidly neutral. Even though the Euro will probably still sell-off, the hawkish bias of the European Central Bank will probably limit the currency’s losses compared to the potential losses of the other currencies. In contrast, if the Fed is more neutral, any dollar weakness will probably be most pronounced against the Euro and less so against currencies the JPY, GBP and NZD.

Continuing on the theme of strong weak pairings post FOMC, given the stark contrast between the monetary policies biases of the European Central Bank and the Bank of England, the clear fundamental divergences in EUR/GBP may make it an attractive currency pair to hide in during FOMC. Even though the US interest rate decision will be tomorrow’s primary focus, it is important to not forget that the Eurozone will also be releasing a lot of very important economic data. This includes German and French unemployment as well as French GDP for the first quarter. If these numbers come out strongly, it will give the European Central Bank an even better reason to raise rates in August. The market is pausing at the moment in anticipation of FOMC, but post FOMC, traders will be able to adjust their positions to incorporate expectations for an August hike. Recall that Euro bullishness receded after the more neutral comments from ECB President Trichet at the last monetary policy meeting. Nowadays, the Euro has a lot going. The World Cup should prove to be a big boost for the German economy while more central banks such as the United Arab Emirates are switching a portion of their reserves to Euros. In addition, over the next 2 months, Russia will be paying their Paris Club debt which is denominated in Euros and is estimated to total $22 billion. They will need to buy Euros to fund a part of the repayment. Meanwhile Swiss economic data continues to beat expectations, which is proving to be very positive for the Swiss Franc. The KoF leading indicators for the month of June rose to 2.50, which should give the SECO good reason to boost their 2006 economic forecasts tomorrow.

British Pound
The British pound is weaker once again against the dollar but the currency could see a bit of boost tomorrow morning on the back of housing market data. Nationwide house prices as well as mortgage approvals and net consumer credit are due for release. Recent data from the housing market has been in line with stabilizing conditions. This is encouraging since it is one of the primary sectors that the Bank of England has its eyes on. However, as we have talked about all week, the BoE has other things on its mind at the moment – namely finding a replacement for the two open posts on their monetary policy committee. For time being, this will prevent the British pound from seeing any meaningful self-induced volatility.

Japanese Yen
Even though the US will be stealing the limelight tomorrow, over the next 2 days, Japan will be releasing a tremendous amount of economic data starting with tonight’s industrial production, trade balance and small business confidence reports. These reports could take the attention off of the Fukui scandal at least for a brief moment, especially Thursday’s CPI report. The CPI will be critical in determining how much longer we have to wait before the Bank of Japan will feel comfortable with raising interest rates. The economy is gradually improving and last night, retail sales increased 0.1 percent, which is much stronger than the market’s forecast for a 0.5 percent drop. Prime Minister Koizumi is set to leave office in September and according to a recent newspaper poll, Chief Cabinet Secretary Abe has so far received the highest support for replacing him. Down south, New Zealand reported horrid economic numbers last night, making the Kiwi the day’s worst performing currency. The trade balance move from positive NZD$50 million to negative NZD$104 million in the month of May while consumer confidence dropped for the third straight quarter as oil prices rise, economic growth slows and the labor market weakens.


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