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FXCM - Dollar Could Still Sell Off with Traders Not Completely Positioned for a Pause

DailyFX Fundamentals 08-07-06

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

- Dollar Could Still Sell Off with Traders Not Completely Positioned for a Pause
- Yen Slides after BP Shuts Down Alaskan Oil Fields
- ECB Officials Continue to Talk of More Rate Hikes to Come

US Dollar - The time is right for the Federal Reserve to pause – at least that is what we have been hearing all day long on the business news stations. Of the 97 analysts surveyed by Bloomberg, over two thirds expect interest rates to be left unchanged at 5.25 percent. However, just because the experts are calling for pause, does not mean that traders are positioned for it. Today, we have been seen a lot of position squaring ahead of the ambiguous rate decision. Fed fund futures are pricing in a less than 20 percent probability of a rate hike tomorrow, but judging from the positions of traders, the chances are more like 60 / 40. Even though the IMM data reported a sharp rise in implied net dollar short positions, we are still far from the extreme short dollar levels that we saw back in May. This suggests that there is nothing standing in the way of further dollar weakness should the Fed really choose to pause. Handicapping the Fed rate decision has been difficult for the past 2 weeks, but positioning for it has become even more challenging with the latest $2 rise in oil prices. British Petroleum has been forced to shut down its Alaska oil fields after tests found severe corrosion in the pipeline. The oil field was the biggest in the US and represented 8 percent of the country’s oil production. Taking this offline would be the equivalent of another Hurricane Ivan for the oil markets. If there is another shock like a brewing Hurricane on top of this, oil prices could easily hit $80 a barrel. This risk could be a good enough reason for the inflation-fearing Federal Reserve to raise interest rates one more time. There are a number of possible scenarios for tomorrow’s meeting. The two most likely ones are either a pause accompanied by a hawkish FOMC statement or a hike accompanied by a neutral statement. Both scenarios are slightly bearish for the US dollar, but not bearish enough to push the EUR/USD far beyond 1.30. The only scenario that has the potential of doing so would be a pause followed by a pessimistic statement. Inflation is and has been a very big concern for the Fed. Tomorrow they will have to decide whether it is a big enough problem for them to risk a recession. A slowdown in growth is already happening and would be worsened by another rate hike. The longer they raise rates, the sooner they will have to cut them. With the future uncertain, the Fed’s best bet would be to leave interest rates unchanged and then warn that if inflation gets out of hand, they could easily raise rates at the next meeting. The fear of this possibility would prevent the market from turning completely bearish. However, if the US government decides to release some of their strategic oil reserves in response to the outage in Alaska, we could see a catalyst for a far deeper slide in the US dollar as inflation risks begin to evaporate. The Fed is bound to drop the curtain on their 2 year long tightening campaign, but when they do so hinges on oil.

Euro - With such an important US monetary policy meeting around the corner, the Euro has come under pressure as some traders square up and move to the sidelines. If the Federal Reserve really opts to leave interest rates unchanged tomorrow, the European Central bank’s clear stance to continue to raise interest rates will become a big theme in the markets. Both ECB members Liebscher and Bini Smaghi talked up the possibility of more rate hikes over the next few months. Bini Smaghi said specifically that the current level of interest rates remains very accommodative and that rates will still need to be readjusted in the coming months. Yet economic data is not holding up as well which suggests that rate hikes will probably be spread out. Retail PMI for the Eurozone fell 1.3 points to 53.8 led by deterioration in activity in Germany, France and Italy. Although the index is still in expansionary territory, it underscores the slower growth that we expect from the Eurozone after the World Cup.

British Pound - The British pound cooled its heels from the tremendous advance in Friday's session. Industrial and manufacturing production both contracted in the month of June. Industrial production slowed 0.1 percent against expectations for an increase of 0.2 percent, while the smaller manufacturing group reported that activity slowed 0.7 percent. Various factors contributed to the slowdown in the nation's dubious factory sector. A strong currency, record commodity prices and hints of a slowdown in the global economy have all added to pressure for firms to cut activity levels to conserve profit levels. The health of British factories has taken on a new level of importance for officials as the central bank's forecast for a rebound in economic growth is partially dependant on the industrials pulling themselves out of the recession it slumped into in 2005. Elsewhere, the recent IMM report showed net long speculative positions in pound futures more than doubled from 22,659 to 45,003 last week. This figure further stuck out because the difference between the commercial and specs has breeched the 100,000-mark - a significant milestone that could be indicative of overbought conditions that have formed after the frenzied bid after Thursday's unexpected rate hike.

Japanese Yen - The yen quietly depreciated across the board Monday as the market responded to higher energy prices that could weigh on both domestic producers' output capabilities and demand from foreign consumers. With crude rallying over 2.0 percent by the end of Asian market hours, the Nikkei equity index dropped 345 points for the biggest one-day decline in nearly 3 weeks. In the currency market the yen followed suit by falling 100 points against the US dollar to position the pair back above the 115 level. While crude was at the front of traders' minds, there were also economic releases to incorporate into positioning. Preliminary reads of June's leading and coincidence indexes provided little shock value as both reported in line with expectations. The coincident indicator of current business conditions advanced for the month to 88.9 percent, the highest read this year. However the more important read was the Leading Economic Index which contracted to a 50.0 percent figure, just on the cusp of the expansion / contraction level. Despite the precarious level, the figure is still indicative of economic growth in the coming three to six months that would make for the longest period of expansion since World War II.

 

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