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Tuesday November 7, 2006 - 22:58:44 GMT -

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Forex - Dollar Sells Off Ahead of Election Results

FXCM - DAILYFX Fundamentals 11-07-06

By Kathy Lien, Chief Strategist of

• Dollar Sells Off Ahead of Election Results
• RBA Raises Rates to 6.25 Percent, Remains Hawkish
• Yen Falls Victim to Fukui’s Comments

US Dollar – After quietly consolidating on Monday, the currency market has finally awakened to align itself with the expectations of the stock and bond markets. This means that all three of the major markets are now anticipating a political gridlock with Republicans losing partial if not complete control of Congress. This also suggests that the market will most likely have a larger reaction to a clean sweep by the Republicans than a Democratic win. The fact that every market has priced in political gridlock, or a Republican win of the Senate and a Democratic win of the House suggests that the actual confirmation of these results may only lead to a mild extension of current dollar sell-off. The reason why a Democratic majority in either group is negative for the dollar is not a matter of what the Democrats will bring to the table, but instead a matter of what they will prevent. They will most likely approve less trade deals and apply more oversight into corporate practices. They will also be much more stringent on government spending and more likely to increase taxes. The only potential dollar positive is their support of an increase in the minimum wage. Higher wages increase inflationary pressures which would keep Fed policy on hold for a longer period time of time. There has been an exceptionally tight leash on the exit polls so it is has been difficult figuring out what is going on behind the scenes. Early exit polls have been quarantined in a secret room with cell phones and blackberrys confiscated until 5:00pm EST. The only word that we are hearing is of all the problems at the poll stations. These problems have been very widespread, which brings back the possibility that the results could be delayed or there could be a fierce debate after the elections on their validity. There is no US data due for release tomorrow which should keep the markets focused on the Midterm election results. Federal Reserve President Moskow is due to speak again on the economic outlook and will most likely reiterate his previously hawkish stance.

Euro and Swiss Franc – The Euro hit a one month high today before retracing as the market positions itself for the release of the US Midterm election results. We want to point out that economic data continues to disappoint regardless of yesterday’s optimistic outlook from the European Union. Despite an up tick in the Eurozone October PMI index, retail sales fell 0.6 percent in the month of September while German industrial production dropped by 0.3 percent. These numbers however are not worrying the European Central Bank who continues to stand by their bias for higher interest rates. ECB member Garganas was the latest to reiterate his belief that monetary policy remains very accommodative and if inflation risks continue to remain above 2 percent rates next year, more rate hikes will be needed. ECB President Trichet was tight lipped about what the market should expect in terms of rates next year. Garganas’ inflation comment sheds a bit more light on that. Should inflation resume its rise next year, expect more hikes. On the flip side, if we see $50 oil before we see $80, expect the ECB to pause. The only piece of economic data due tomorrow is the German trade balance, which means that there will be no distractions to draw away from the US Midterm elections. Switzerland confirmed its unemployment rate at 3.1 percent, which is the fourth consecutive month that it has remained at that the level. This is also the tightest level that the country’s labor market has been since 2002.

British Pound – Stronger retail sales has helped the British pound rally against both the US dollar and Euro. According to the BRC, October sales increased from 2.4 percent to 2.6 percent, which is quite encouraging given the same month drop in the CBI index. The market is primarily focusing on the Bank of England monetary policy announcement this Thursday. The prospect of another interest rate hike by the central bank is keeping the currency bid and will continue to should we get a positive political surprise for the US dollar.

Japanese Yen – Short yen carry trades are beginning to be reversed after Bank of Japan Governor Fukui said last night that they would not “hesitate to lift rates if needed.” Fukui has fallen victim to the political disease called flip flopping and is confusing the markets along the way. Just last week, Fukui said that the central bank is in no rush to raise interest rates and now he is saying that they will adopt a forward looking approach. Either way, Fukui is talking about the inevitable and we have been warning for weeks that short yen carry trades are becoming dangerously risky investments. We also want to point out that whenever we cross the 150 mark in EUR/JPY, politicians from either Japan or another country steps in to talk down the currency. Last time it was the Russians and this time it is the Japanese themselves.

Commodity Currencies (CAD, AUD, NZD) – Commodity currencies continued to strengthen today despite the lack of economic data overnight as the US dollar took the driver seat for all of the currency pairs. At the end of the US trading session, the Reserve Bank of Australia announced a decision to raise interest rates by a quarter point to 6.25 percent. This decision was widely expected by the market, but the exceptionally hawkish comments from the central bank were not. The RBA said that there is evidence of higher inflationary pressures and therefore also a very strong risk that inflation will exceed their 2 to 3 percent target. They also feel that the labor market remains tight and the economy has limited spare capacity with wages growing at faster than average pace. Overall, these comments suggest that the RBA remains hawkish and is on track to continue increasing interest rates in the months ahead. Interestingly enough, the Australian dollar did not respond positively to this decision. This appears to be completely priced into the market and traders are instead looking forward to the release of the quarterly Statement on Monetary Policy next week.


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