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Thursday June 29, 2006 - 21:06:51 GMT

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FXCM - US Dollar Melts Down Post FOMC

DailyFX Fundamentals 06-29-06

By Kathy Lien, Chief Strategist of

• US Dollar Melts Down Post FOMC
• Strong German Data Boosting Gains in the Euro
• Busy Japanese Calendar Could Cause More Volatility in the Yen

US Dollar - As promised, the currency market was extremely exciting today with breakout moves in many of the major currency pairs. Yesterday we had outlined three of the five most likely scenarios for the Fed meeting today and in line with our predictions, the Federal Reserve opted for one of them, which is to raise rates by a quarter of a point and to accompany that with a less hawkish statement. More specifically, they said that any further policy moves would be dependent upon the outlook for both inflation and economic growth. This puts to doubt whether we will see another rate hike in August and traders are still left guessing. However, unless Bernanke really wants to be known as mixed message Ben, we have probably seen the last of the Fed’s rate hikes. With the Fed finally acknowledging the impact of their interest rate hikes on growth and the housing market, 5.25 percent rates will only exacerbate the pain of adjustable rate mortgages, especially at a time when oil prices have ticked higher once again. The last time Bernanke and team hinted at a pause was back in late April and if you recall, that was what caused the EUR/USD to rise from 1.24 to 1.2975 and the USD/JPY to drop from 115 to 109. The shift in today’s statement could be just what the dollar is waiting for as the catalyst to tip over. The Fed fund futures indicates that even though expectations for an August rate hike have been pared back, the market is still pricing in an above 50 percent probability for another hike sometime this year. This makes incoming economic data even more important because if data begins to sour, then we can close the door on any more rate hikes. Alternatively, if the outlook improves while energy or other prices remain high, then a rate hike in August or September could still be possible. We have a full month until the next meeting and judging from the statement, the reports that we need to keep an eye on are productivity, labor market and inflation gauges. Either way, there is no doubt that sentiment has shifted in the market and that dollar bears are gaining the upper hand as technicals and fundamentals favor a turn in the market. The two US reports that were released today, though still reflective of solid growth did not satisfy dollar bulls who were looking for strong numbers to confirm the possibility of a more hawkish stance from the Fed. Even though GDP growth was at a 5.6 percent pace in the first quarter, the price index and personal consumption components of the report were slightly weaker than expected while jobless claims ticked higher.

Euro - Yesterday we said that the Euro has a lot going for it and today it has even more. With the outlook for another US interest rate hike now uncertain, the clear hawkishness of the European Central Bank and the solidly strong economic data from Germany should be extremely positive for the Euro. Things are going well in Germany and should only improve with the World Cup. Unemployment in the month of June dropped by a more than expected 49k, brining the unemployment rate down from 11.0 percent to 10.9 percent. Factory orders also increased by a much more than expected 4.1 percent signaling a strong acceleration in manufacturing activity. French GDP was right in line with expectations while annualized money supply growth (M3) accelerated slightly more than expected. Tomorrow we have a lot more Eurozone data due for release including the business climate indicator for the region, German retail sales and French consumer confidence. Given the sharp up ticks in German and Italian business confidence, the regional confidence index should also rise. If German retail sales come in strongly, we could see the EUR/USD up at 1.26. We had promised to update our SSI numbers from this morning, as of 5pm EST, the EUR/USD ratio flipped from 1.18 to -1.07 while the USD/JPY ratio is at parity, the GBP/USD ratio remains positive at 1.38 compared to 1.43 along with the USD/CHF ratio which is at 1.58 compared to 1.18.

British Pound - Even though UK economic data was mixed, dollar bearishness pushed the British pound higher. As we mentioned yesterday, the comparative weakness in the UK would make dollar weakness more pronounced in the EUR/USD than the GBP/USD, which was exactly what we saw today. Comments from the Bank of England were more neutral today and come in contrast to the slightly more hawkish comments from Bank of England Governor King back in late March when he said that there is risk for inflation to overshoot the central bank’s forecast. Today, he talked about how inflation now remains low and that there are risks for weaker growth. BoE Deputy Governor Barker was a bit more direct as she noted the recent fall in inflation as something the central bank is quite pleased about. Housing numbers were mixed with Nationwide house prices increasing less than expected, but mortgage approvals and net lending increasing more than expected. This could mean that the more attractive prices are driving demand.

Japanese Yen
Industrial production was weaker than expected in the month of May, falling 1.0 percent after rising 1.4 percent the previous month. Even though this number is far short of expectations, the market was not that disappointed because productions plans for June are strong, which could pave the way for a nice rebound in the following month’s report. Tonight we have far more important releases including consumer prices, household spending, manufacturing sector PMI and labor market data. CPI is key and will shed more light on how far away we may be from a Bank of Japan rate hike. Meanwhile speculation surrounding more Chinese revaluation has also sparked yen buying at the onset of European trading. According to a state media report, China is working on a broad scale effort to inform the country’s textile firms on the need to prepare for more flexibility in the country’s currency. These are all gradual steps that are mandatory before the country can move to a free float. As an export dependent economy, the value of the Yuan will have a significant impact on the health of Chinese corporations and the sustainability of the country’s double digit growth rates. Another revaluation move is inevitable and we are inching ever so closer to that possibility. The Japanese Yen has long been one of the favorite ways for traders to express expectations for Chinese revaluation due to the close trade between the two countries.


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