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Forex - British Pound: One More BoE Rate Hike This Year?

DailyFX Fundamentals 06-06-07

By Kathy Lien, Chief Strategist of DailyFX.com

- New Zealand Dollar Hits 25 Yr Highs After Interest Rates are Raised to 9 Year High – More To Come?
- Is the Dollar Tumbling Because of the Dow?
- British Pound: One More BoE Rate Hike This Year?

New Zealand Dollar Hits 25 Yr Highs After Interest Rates are Raised to 9 Year High – More To Come?

The NZD/USD hit a fresh 25 year high after the Reserve Bank of New Zealand surprised the market by raising rates to 8 percent, which is a 9 year high. This very dynamic is what will keep carry trades alive and well even if the Dow is falling. Although RBNZ Governor Bollard finds the exchange rate unjustifiably high, the 60 percent surge in dairy prices has forced him to fight inflation as aggressively as he can. According to Bollard, domestic spending and overall growth is strong enough to weather 8 percent interest rates. Even though he refuses to comment on future rate decisions, the futures curve is pricing in one more 25bp hike by the end of the year with a slim chance of two. The AUD/USD is also performing well, having hit a fresh 16 year high after strong GDP numbers. Employment data will be the key whether this strength can continue. Despite weaker IVEY PMI and building permits, Canadian dollar bulls refuse to give up.

Is the Dollar Tumbling Because of the Dow?

The Dow Jones Industrial Average tumbled over 100 points today, bringing the US dollar down with it. The most significantly weakness has been seen against the Japanese Yen, Australian and Canadian dollars but the fact that the US dollar has held steady against the Euro and British pound indicates that this is not a dollar story. True economics is back in play as the price action of each currency pair reflects the country’s own outlook for interest rates. Take the AUD/USD for example. It is the best performing pair of the day because the market now believes that the Reserve Bank of Australian will raise rates this year. The EUR/USD on the other hand is weaker because the comments from ECB President Trichet today suggests that the central bank will be hold at least until September. Unit labor costs and productivity were the only pieces of data on the US calendar today and these final quarterly releases are never major market movers. Therefore even though productivity slowed in the first quarter while unit labor costs increased, the US dollar did not budge. Instead, everyone has their eyes on the US stock market which dropped after Morgan Stanley issued a triple sell warning. This was the first time since the tech bubble burst that all three of their key warning indicators which follow P/E ratios, growth, inflation and risk appetite call for a correction. In fact, their model is predicting a 14 percent drop over the next six months. We have said often that carry trades will die with the Dow dies. Now that it is beginning to, we are seeing the currency component unfold as well. Therefore should the weakness in stocks continue, we expect to see a further sell-off in USD/JPY. The hawkish comments from Federal Reserve Presidents Lacker and Pianalto suggest that central bankers are happy with the correction. Wholesale inventories and wholesale sales are the only US releases on the docket tomorrow so we do not expect any major price action in the US dollar. Continue to watch the Dow for direction.

ECB Comments Put a Lid on Euro Rally

The European Central Bank raised interest rates by 25bp today, bringing their target rate up to 4.00 percent. This move was widely expected, which explains why the Euro did not react to the rate announcement. Instead, the volatility came when ECB President Trichet began to speak. Although he said that rates are still accommodative, he made no mention of the words “strongly vigilant.” In yesterday’s Daily Fundamentals, we pointed out that this is his general mode of operation. Unless the ECB plans on delivering a back to back rate hike, which they have not done since 2000, they always reduce their degree of hawkish. In March 2007 and December 2006, which were the last two times that they raised interest rates, the Euro fell for this reason. No guessing is needed about what happens in June as this shift in rhetoric is a clear indication that rates will remain unchanged. Yet, the retention of the overall hawkish bias still indicates that another rate hike could come in the third or fourth quarter. German factory orders were mixed with the monthly figures dropping more than expected but the annualized figures improving. This suggests that the monthly growth in German industrial production, which is due for release on Friday could fall short of expectations as well. Switzerland has employment figures due for release tomorrow morning. The overall health of the economy should bring the unemployment rate down from 2.9 to 2.8 percent.

British Pound: One More BoE Rate Hike This Year?

Like the Euro, the British pound has held up very well against the US dollar. Consumer confidence hit a one year high in the month of May while wage growth neared its 7 year high. Collectively, these numbers suggest that we could see strong retail sales in the month of May, which would pave the way for another rate hike by the Bank of England this year. The futures curve is fully pricing in one rate hike with a slim but growing possibility of two hikes. We will not likely see the rate hike tomorrow however since they just raised rates in May. Even though the economy remains strong, they do not want to be the ones to push the GBP/USD above 2.0. When they leave interest rates unchanged, no statement is released, but here’s a word of caution: when it comes to the Bank of England, traders should not rule out anything since they are a central bank that is notorious for catching the market off guard.

Yen Rallies on Dow Weakness

The Japanese Yen is stronger against every major currency except for the Australian dollar as the reversal in the Dow triggers the reversal of long carry trades. This will continue to be the primary driver for the Yen since the Japanese economic calendar is devoid of any significant economic data. Both the leading and coincident numbers released last night were right in line with expectations. The weakness in carry trades could be limited by the fact that many of the central banks in question such as the Reserve Bank of Australia, Bank of England and Canada are still set to raise interest rates again this year. Wider rate differentials are beneficial for carry trades.

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