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Wednesday August 9, 2006 - 21:33:35 GMT
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FXCM - Yen Weakens as Bank of Japan is Expected to Leave Interest Rates Unchanged

DailyFX Fundamentals 08-09-06

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

- Yen Weakens as Bank of Japan is Expected to Leave Interest Rates Unchanged
- Summer Doldrums Hits EUR/USD
- Pound Retraces Following Disappointments From the Trade Balance and Inflation Report

US Dollar

Summertime is the season for long vacations and we are finally feeling it in the currency market. With the big event of the year, namely the end of the Federal Reserve’s two year long tightening cycle behind us, traders can finally breathe a sigh of relief and be fully relaxed on the beach without having to worry about whether they will be missing out on a big shift in the currency markets. In fact it is no secret that many European interbank traders like to take the whole month of August off and leave their most junior dealers on the trading desks. This means that the range trading that we have become familiar with over the past 3 months could very well continue until Labor Day. The Euro quietly creeped higher today and we expect the trend of small gains to continue. The US dollar is still yielding 225bp more than the Euro and until the European Central bank steps up to close that gap further, the Euro will probably fluctuate within a 1.27 to 1.30 trading range. We can clearly tell from the price action in the EUR/USD over the past two days that even though the Federal Reserve has ended their tightening cycle, there are many traders who need more proof that they are truly done with raising rates for the remainder of the year. These traders are most likely holding out for Friday’s retail sales reports which is expected to rebound significantly in the month of July after contracting 0.1 percent the month prior. However with all of the pressures of higher energy costs and mortgage payments, we think that it is highly unlikely retail sales will accelerate by the pace that economists are predicting. The current forecast is for a 0.8 percent rise in retail sales, which would be the strongest increase in spending year to date. Before shifting our attention completely to consumer spending, we will first turn our focus to the trade balance report. The deficit due out tomorrow is expected to worsen for the third month in a row as rising energy prices increase the value of imports. The problem is not just with the deficit unfortunately. We are seeing more and more signs that foreign investors no longer find dollar denominated investments attractive. The equity market has been range bound all summer and the Federal Reserve is no longer offering an increasingly attractive yield. The ten year bond auction today received below average demand which confirms that if the US government wants more money to flow in to support the dollar, they will have to do a much better job. A larger trade deficit report would be bad, but a significantly low amount of net foreign purchases of US securities (report due out next week) would be worse. As we see it, the outlook for the US dollar is not promising and will remain so until the US economy reheats or oil prices spike again, which would force the Fed to reinitiate its tightening cycle.

Euro

With no news on the plate, the Euro continues to benefit from the divergent monetary policies of the Eurozone and the US. We remain very cautious however on the fundamental outlook for the Eurozone economy as we begin to see deteriorating economic data in the region. We are sure that we are not the only ones to notice this and if the trend becomes more widespread, there is a very strong likelihood that the European Central Bank will follow in the footsteps of the Federal Reserve by cutting short their interest rate hikes. So far, we have yet to hear any hawkish rhetoric from ECB officials and if we still do not over the next few weeks, we will have growing suspicion that the central bank may be reconsidering the course of its own monetary policy. In all likelihood though, the ECB will probably deliver an interest rate hike in September and then end it there, as long as energy prices do not stray far from current levels. Tomorrow we are expecting the ECB monthly bulletin for August. Put together in July when economic activity was still relatively robust, the report is more likely to take an optimistic tone. However weaker French industrial production numbers could offset some of the positive sentiment.

British Pound

After eight straight days of strong gains in the British pound, we are finally seeing signs of exhaustion. The UK trade balance shrank less than expected in the month of June driven primarily by a larger drop in imports than exports. However the concern is that the recent rise in the British pound will hurt the export sector going forward, which could ultimately filter into a larger trade deficit. Looking at monetary policy, the outlook for another rate hike by the Bank of England later this year is still unclear. The central bank increased its outlook for growth and inflation in its Inflation report, but downgraded the outlooks further out. So it is then up to incoming economic data to determine whether the economy has what it takes to handle another rate hike if oil prices rise or heats up enough to warrant more tightening. Unfortunately we will not get more clues on this until next week with no significant UK economic data due over the next two days.

Japanese Yen

The Japanese Yen is weaker against all of the major currencies going into tonight’s Bank of Japan monetary policy meeting. The central bank will announce their rate decision when their two day meeting draws to a close tomorrow night. With the BoJ and government officials battling out the state of deflation, there is no chance that they will raise interest rates again this week. However, Bank of Japan Governor Fukui will be making comments after the board meeting, so it will interesting to see if he gives any clues about when the next rate hike will come. We still expect one later this year, possibly in October or November, depending upon how the Japanese and global economy performs. Meanwhile machinery orders were very strong last night and we will need to see more solid reports to give the BoJ the ammunition they will need to convince the government that another rate hike is needed. Consumer confidence and the Consumer Goods Price Index due out tonight could be a good start.

 

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