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Forex - US Dollar Strengthens as Inflation Data Surprises to the Upside

FXCM - DailyFX Fundamentals 02-21-07

By Kathy Lien, Chief Strategist of DailyFX.com

• US Dollar Strengthens as Inflation Data Surprises to the Upside
• Japanese Yen Remains an Attractive Funding Currency
• Stronger Commodity Prices Trigger Sharp Gains in CAD, AUD and NZD

US Dollar

US consumer prices were slightly better than expected today which helped to contribute to the overall strength of the US dollar. Having rallied going into the release of the CPI report, the true impact on the dollar was limited. Central banks were the focus of the day with interest rate decisions, comments and minutes from prior meetings occupying the calendar. The Bank of Japan’s decision to raise interest rates gave little support to the Yen in light of the dovish comments from BoJ Governor Fukui following the decision. The British pound remained under pressure as the minutes from the most recent BoE meeting suggests that the central bank will need more time to assess data before tightening rates again. Comments from the central bank governors of Australia and Switzerland indicate that both policy makers are looking to lift interest rates over the next year. In the US, the minutes from the January FOMC meeting delivered no surprises. The Federal Reserve was relatively upbeat about growth and agreed that inflation risks still remain. Even though another rate hike was “not warranted” at the time, they decided against dropping the tightening bias. The tone of the statement contained the same degree of hawkishness as the comments made by Fed Chairman Bernanke last week, which should keep the prospects of a rate hike later this year in play. A deeper look at today’s US data indicates that the rise in core prices was driven by higher medical costs and tobacco prices. Leading indicators fell short of expectations for the month of January, but the sharp upward revision in December offset any negative implications. Looking ahead, the dollar could retain its strength against the Japanese Yen and British pound because of the divergence in monetary policy outlooks between the US, Japan and Great Britain. At the same time, it could be vulnerable to further losses against the Euro and commodity currencies, where the monetary policies of those countries are slightly more aggressive than that of the US.

Euro

The Euro is slightly higher against the US dollar today thanks to a stronger current account report, hawkish monetary policy and carry trade demand for the Euro against the Japanese Yen, which hit a fresh record high today. Not only did the Eurozone current account surplus increase instead of decrease in the month of December as the market expected, but the November balance was also revised from -2.0B to 0.9B. Consumer prices in France and Italy were slightly weaker than expected but not enough to shift the ECB’s monetary policy outlook. The second release of German GDP is scheduled for tomorrow but no changes are expected. The bid tone in the EUR/USD today is primarily related to EUR/JPY demand. Carry trades are back in play after the BoJ signaled that further rate hikes will be slow and gradual. The Euro has become one of the preferred carry trade currencies to earn interest on because of the central bank’s plans to raise interest rates next month. The market has paid zero attention to the resignation of Italian Prime Minister Prodi which could catch up to the Euro in the coming days. Meanwhile Switzerland’s central bank President Roth said that interest rates were too low to control inflation. However the impact on the Swiss Franc was limited because he expects the economy to weaken in the second half of the year.

British Pound

The British pound is weaker against the US dollar and the Euro after the release of the minutes from the most recent monetary policy meeting. The committee voted 7 to 2 to leave interest rates unchanged at 5.25 percent. Once again, Besley and Sentence who are typically categorized as hawks voted in favor of an interest rate hike. However the other members of the monetary policy committee voted against one because they felt concerned about delivering rate hikes that were too closely spaced together. They wanted to give the economy time to absorb the latest rate hikes and also wanted to avoid over tightening. The take away message is that the BoE has adopted a wait and see approach like the Fed and will not be raising interest rates in March or April. Near term inflation is expected to drop and the BoE will want to wait to see a pickup before driving rates higher again. The CBI industrial trends survey was the only piece of UK data released today. The index surged from -9 to 4 in the month of January, suggesting a recovery in manufacturing.

Japanese Yen

The Japanese Yen dropped through the floor today despite an interest rate hike from the Bank of Japan. As we suggested yesterday, regardless of how the BoJ swings, the yen may not rally on the back of the rate decision. This was how things unfolded over the last 12 hours as cautious comments from the Bank of Japan reinforced the market’s belief that despite the increase, interest rates will remain low and any further rate hikes will be delivered gradually. We expect the Bank of Japan to repeat what they did back in July of 2006, which is to give the market at least 4 to 6 months to absorb the latest rate increase before tightening policy again. As an export dependent nation, Japan does not want to see a rapidly appreciating Yen and they especially do not want to trigger massive carry trade liquidation. At 0.50 percent, Japan still offers the lowest yield in the developed world, which is keeping the Yen an attractive funding currency for carry trades.

Commodity Currencies (CAD, AUD, NZD)

The Commodity Currencies are stronger across the board and they have good reason be to with gold prices up $21 an ounce to a 9 month high and oil prices back above $60 a barrel on news of refinery shutdowns. The Canadian dollar staged the strongest rally thanks to its solid retail sales figures for the month of December. Holiday spending proved to be exceptionally strong which is another piece of evidence that the Canadian economy is improving. The recent string of positive reports has driven the Canadian dollar to a 6 week high against the US dollar. The Australian dollar is also performing well thanks to the hawkish comments from RBA Governor Stevens last night. He was optimistic about growth said that rates were more likely to rise than fall. His comments were reinforced by the stronger fourth quarter wage data and leading indicator reports released last night. For the time being, carry trade demand continues to keep both the Aussie and Kiwi bid.

 

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