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Tuesday July 18, 2006 - 21:43:09 GMT

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FXCM - Strong Inflation Report and Foreign Investment Boosts Dollar

DailyFX Fundamentals 07-18-06

By Kathy Lien, Chief Strategist of

• Strong Inflation Report and Foreign Investment Boosts Dollar
• Euro Fell on ZEW Survey, but IFO may be More Telling
• Pound Rises on its Own Accord

US Dollar
Surprises were the day’s themes as most US numbers came in much stronger than expected while Eurozone numbers took a surprise turn for the worse. Not only did we see producer prices grow by a faster pace in the month of June, but net foreign inflows were also solid in the month of May. More specifically, a surge in food prices drove headline producer prices up 0.5 percent, compared to the market’s forecast for a tamer 0.3 percent rise. The growth of core prices however was a bit steady, which muddles the inflation outlook somewhat. Having grown by 0.3 percent in May, core prices grew by only 0.2 percent in June. The sharp rise in food prices and today’s PPI number in general suggests that we could see a stronger headline CPI report. The growth of core prices however could remain modest. Yet it seems that Bernanke focuses more on the overall inflation picture rather than just the trend of core prices. As such, traders are expecting a tinge of hawkishness, if not an outright indication of another rate hike at his semiannual testimony on the economy and monetary policy before the Senate tomorrow morning. Bernanke will need to walk a fine line if he doesn’t want to be known as mixed message Ben. At the last monetary policy meeting in June, the Fed toned down their FOMC statement by qualifying the need for another rate hike based upon incoming inflation and economic data. Although inflationary pressures have increased, a shift from a less hawkish back to solidly hawkish stance would have the critics kicking and screaming about how Ben can not make up his mind. Meanwhile foreign investment was surprisingly strong in the month of May. Flight to safety has prompted strong demand for dollar denominated assets, particularly US bonds which now offer a nice yield. Originally expected to only increase by $58.4 billion, foreign investment actually exceeded the same month’s trade deficit, rising by $69.6 billion. Yet not all news was goods news, central banks actually dumped $14.3 billion worth of bonds, the largest amount in over seven years (validating the trend of reserve diversification). In addition, the NAHB homebuilders’ index fell to the lowest level in 14 years. This indicates that even though inflation pressures remain high, there are clear signs that the economy is beginning to weaken and should the Fed persist with their interest rate hikes, they will at the same time raise the possibility of a recession. Bernanke has quite a task before him and one that we can only hope he handles well.

With the World Cup behind us, the German ZEW survey has brought the first warning sign of the hurdles that the Eurozone economy faces in the months ahead. Although analysts were very optimistic on current conditions, they were extremely pessimistic on future conditions. Spending from visitors around the world led to a big boost in economic activity. In fact, the excitement in Germany was so overwhelming that consumer confidence hit a five year high last month while business confidence climbed to a 15 year high. However going forward, the Eurozone has to rely on itself to generate additional growth. Analysts are worried that this may not be that easy with oil prices rising, tensions in the Middle East, political turmoil in Berlin and the potential impact of higher interest rates. Things may not be that bad however since analysts have been increasingly pessimistic for the seventh straight month although businesses remained optimistic. According to comments by Trichet in late June, the ECB pays “very close attention” to the work of the IFO institute and noted that it is an index that they “carefully read each month.” Therefore today’s weak ZEW survey could hold little weight if business sentiment remains high. Only time will tell how long the World Cup effect will continue to be felt in the Eurozone.

British Pound
Over the past week, we have watched the British pound outperform the Euro in the face of strong Eurozone economic data and weak UK data. The balance has flipped today and has given a solid explanation for the British pound’s strength against both the Euro and the US dollar. In contrast to the surprisingly weak German ZEW survey, UK consumer prices rose by 0.3 percent, beating the market’s expectation for a 0.1 percent rise. This brought the annualized pace of growth from 2.2 percent to 2.5 percent. Core CPI also ticked higher from 1.1 percent to 1.2 percent. The Bank of England has previously downplayed inflation pressures and today’s report raises the question of whether they should. UK Treasury’s Balls was the first to say that the latest report necessitates a more vigilant and forward looking stance by monetary policy makers. The BoE however may choose to remain on the sidelines until their two additional members join in September and October. The addition of the two new members later in the year will also downplay the significance of tomorrow’s minutes from the July MPC meeting.

Japanese Yen
After last week’s interest rate hike by the Bank of Japan, Japanese Yen traders are left with little to work with. The Japanese economic calendar is completely empty aside from a speech by Deputy Governor Muto on Friday. The Bank of Japan has indicated that for the time being, they are in rush to follow up the quarter point hike with a series of rate hikes. Even though many analysts expect one and maybe even two more hikes later this year, the gap of time between the first and second one will probably be at least two months. The BoJ waited four months between the end of quantitative easing before ending their zero interest rate policy. In the meantime, developments in China continue to influence the Yen. Another quarter of double digit GDP growth highlights the difficult time the government is having with taming their economy. As a big trade partner of Japan, stronger growth in mainland should benefit its Eastern neighbor.


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