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Friday June 1, 2007 - 21:44:37 GMT -

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Euro: ECB Expected to Raise Rates Next Week

DailyFX Fundamentals 06-01-07

By Kathy Lien, Chief Strategist of DailyFX.

- US Dollar: Strong Payrolls Not Enough to Offset Softer Inflation and Weak Income
- Euro: ECB Expected to Raise Rates Next Week
- Japanese Yen Crosses and Canadian Dollar Hit Fresh Decade Highs

US Dollar: Strong Payrolls Not Enough to Offset Softer Inflation and Weak Income

Living up to its reputation, the non-farm payrolls report delivered some serious volatility to the foreign exchange markets. An intraday chart of the EUR/USD revealed rollercoaster like price action which illustrates the difficulty in trading the EUR/USD on non-farm payrolls day. Interestingly, the cleanest NFP reaction was actually in USD/JPY, which trended higher throughout the US trading session. Non-farm payrolls were strong, with corporations adding 157k jobs in the month of May. Manufacturing ISM also beat expectations, rising to 55.0 from 54.7. However this was not enough to negate the day’s disappointments. Personal income dropped for the first time since August 2005 while spending continued to rise. The spread between income and consumption is the widest since May 2006, indicating that consumers are digging deeper in their pockets to fund their purchases, which is never healthy. Evidence of housing market weakness continues to pour in with pending home sales dropping 3.2 percent in the month of April. Inflationary indicators were slightly softer with the PCE core deflator and prices paid falling short of expectations. The bottom line is that the Federal Reserve will continue to stand pat for the remainder of the year. Ten year bond yields rose to 4.95 percent, the highest since August 2006. With the stock market hitting another record high, the Fed will not want to risk creating a bubble by lowering interest rates prematurely. Steady rates benefits USD/JPY but has no immediate impact on the EUR/USD since traders of that pair are focused on next week’s ECB rate decision. The economic calendar is relatively light for the US, but the data that is due for release are important. We are expecting factory orders, service sector ISM, and the trade balance. Federal Reserve Chairman Ben Bernanke will also be speaking on the hot topic of housing and the economy.

Euro: ECB Expected to Raise Rates Next Week

The Euro held up very well despite the stronger US ISM and non-farm payrolls figures. This strength was partially due to robust German retail sales in the month of April which tripled expectations. The market is looking at this number as a validation of a need for further rate hikes next week. ECB President Trichet said this morning that second round inflation effects must be avoided. This language suggests that a hawkish stance after June is not out of the question. What happens after June is will be everyone’s focus next Wednesday. The central bank has provided little clues on where they stand and data has been mixed. For example even though we had solid spending numbers from Germany this morning and a lower unemployment rate for the region as a whole, manufacturing PMI was softer that expected. Data earlier in the week could help to clear the air a bit with Germany factor orders, Eurozone service sector PMI and producer prices due for release. Meanwhile Swiss data fell short of expectations today with Swiss PMI slipping from 61.9 to 58.9. It seems that even though the franc has remained weak, Swiss businesses are actually less optimistic about business activity. The current account surplus edged higher while consumer prices were right in line with expectations. Unemployment is the only release on the calendar next week.

British Pound: Bank of England Meeting Expected to be a Nonevent

Like the Euro, the British pound held up very well against the US dollar today. In fact, the currency is up across the board thanks to the highest manufacturing PMI reading in 8 months. Both input and output prices increased, which is reflective of the higher prices charged by businesses. Although the UK economic calendar was relatively light this past week, it picks up in the week ahead. We are expecting construction sector PMI, retail sales, service sector PMI, more house price reports, industrial production and another Bank of England rate decision. Unlike the ECB, where the rate decision is expected to be a big market mover regardless of which way the central bank sways, the BoE rate decision will most likely be a nonevent. Having just raised rates last month, even though the central bank could still raise rates again in the months to come, mixed data will prevent them from lifting rates in June. When the BoE leaves rates unchanged, they do not issue any comments or statement, which is why there could be little reaction to the rate announcement.

Japanese Yen Crosses Hit Fresh Decade Highs
One look at the Dow and it is not hard to guess how the Japanese Yen behaved over the past 24 hours. Another record high in the US stock market has sent the yen tumbling once again. Carry trades have continued to perform well with AUD/JPY hitting a fresh 15 year high, NZD/JPY a 17 year high, CAD/JPY a 15 year high and GBP/JPY a 9 year high. As we have said often, the carry will die only when the Dow dies and at this point, the Dow remains strong. The Chinese stock markets are also continuing to rebound, which raises the risk of another policy change by the Chinese government over the next few weeks. Unlike the rest of the world, there is barely any data of consequence in Japan, so expect stocks to continue to drive the currency’s performance.

Strong Performance Seen across all Commodity Currencies

The commodity currencies continued to perform extraordinary well today. The Canadian dollar hit a fresh multi-decade high against the US dollar after Canadian Prime Minister said that it would be a “huge mistake” to interfere with the appreciation of the Canadian dollar. This clearly indicates that the government has no plans to intervene in the currency pair. In fact, parity is now the main target for USD/CAD traders and pretty soon we could actually be there. IVEY PMI, unemployment and trade are due for release next week, all of which are potentially market moving Canadian data. Australia reported very strong manufacturing PMI overnight, which is contributing to the overall strength in both the Aussie and Kiwi. The central banks of both Australia and New Zealand have rate decisions due next week along with Australian unemployment and GDP.


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