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Monday August 14, 2006 - 21:05:22 GMT

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Forex: Dollar Rallies as Traders Bank on Stronger Inflation Reports

DailyFX Fundamentals 08-14-06

By Kathy Lien, Chief Strategist of

• Dollar Rallies as Traders Bank on Stronger Inflation Reports
• GDP Data Indicates Strongest Eurozone Growth in Six Years
• Swiss National Bank Continues to Talk of Need for More Rate Hikes

US Dollar

The US dollar is higher today as traders bank on the release of strong inflation numbers this week. Despite the Federal Reserve’s decision to keep interest rates unchanged for the first time in over two years at their latest monetary policy meeting, not everyone is convinced that the pause represented an end to the current tightening cycle. Last Friday’s upside surprise in retail sales illustrated the resilience of the US consumer and suggested that growth could remain steady. If inflation, which is the Fed’s other main focus also comes in strongly then the minority that is still calling for another rate hike could slowly become the majority. Oil prices averaged $74.44 last month compared to an average price of $70.97 in the month of June which suggests that there is indeed a big risk for headline consumer and producer prices to rise sharply. However, even if it does, we still believe that it would take a lot to convince the Federal Reserve to restart their tightening cycle. There is no doubt that the overall economy is slowing and as much as the price of oil increases inflation, it also hampers growth. The markets are very thin this week as the summer holidays take its toll on volatility. Aside from expectations of stronger US numbers, the dollar is also benefiting from lower oil prices and easing geopolitical risks. A ceasefire between Lebanon and Israel has been declared while the US and the UK have downgraded their terrorist levels after the airline sector scare last week. Oil prices are also lower after British Petroleum announced that while they fix the severe corrosion in their Alaskan pipelines, they will be able to pump half of their regular daily output. Meanwhile PPI will not be the only number to watch tomorrow. We are also expecting the Treasury’s report on net foreign purchases of US securities. Analysts are predicting that foreign demand only dropped off slightly in the month of June but recent decisions from central banks around the world suggests otherwise. Reserve diversification has picked up significantly over the past few months and this trend is expected to be reflected in the TIC report. A sharp falloff is not expected however since US bonds still offer an extremely attractive yield. Yet, if foreign demand fails to meet the same month’s trade deficit, the US’ structural problems could begin to pressure the dollar once again.


The Eurozone reported the strongest growth in six years and yet, the Euro failed to rally. Such is the nature of the currency markets where the fate of the US dollar frequently dominates trading. A pickup in domestic demand as well as increases in capital spending has pushed the annualized pace growth in the Eurozone from 2.0 percent to 2.4 percent. Preliminary figures from Germany suggest that growth in the Eurozone’s largest economy played a large role in boosting the region’s overall growth. German GDP accelerated from a year over year rate of 1.7 percent to an impressive rate of 2.4 percent. Although the solid growth number gives the European Central bank the ammunition it needs to raise interest rates again over the next few months, it should not be mistaken that GDP is a backward and not a forward looking indicator. One more rate hike could be on the table, but with monthly indicators signaling slower growth, we would need to hear a verbal confirmation from central bank officials. Meanwhile over in Switzerland, the outlook for the Swiss Franc continues to look extremely promising. Swiss National Bank President Roth reiterated the central bank’s need to gradually raise interest rates and even went so far as to say that given the current risks to price stability, they may need to accelerate that pace. With the economy booming, the SNB could raise rates at least two more times this year, which would be bullish for the Swiss Franc.

British Pound

Even though the UK lowered its terror alert level, the British pound has weakened against both the US dollar and the Euro. Subsiding geopolitical risks is bringing economics back to the forefront and today’s release of producer prices was mixed at best. Input prices rose more than expected by 1.1 percent but output prices on both a headline and core level grew at a slower pace in the month of July. In fact, the month to month rise in core output prices was the weakest since last October. Leading indicators also fell by 0.1 percent in the month of June driven down primarily by the slide in the equity markets. This suggests that for the time being, the Bank of England will not follow-up their surprise rate hike earlier this month with another unexpected move. However, before rushing to a final judgment, there is still a great deal of UK data due that could shift the outlook this week.

Japanese Yen

With many Yen traders off for the Obon Summer Holiday (which ends in late August), the Japanese Yen continued to sell-off against many of the majors. The extension of pessimism following last week’s disappointing GDP report was exacerbated by the rise in bankruptcies reported in the month of July. However, we believe that the economy is not doing as poorly as the GDP report which is a backward looking indicator indicates. The recent fall in the Japanese Yen should have a stimulative impact on the economy while the latest drop in oil should help lower the burden on Japanese consumers. In fact, oil prices have just broken out a seven month trendline, which suggests that a further drop in prices could be likely.


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