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Forex - Carry Trades Rebound as Profit Taking Comes to an End, Party Not Over Yet

DailyFX Fundamentals 06-28-07

By Kathy Lien, Chief Strategist of

• Fed Meeting Over: What Next For the US Dollar?
• Carry Trades Rebound as Profit Taking Comes to an End, Party Not Over Yet
• New Zealand Dollar Hits 25 Year High as Strong Data Signals More Rate Hikes

Fed Meeting Over: What Next For the US Dollar?

The Federal Reserve monetary policy meeting is now behind us and with no major changes to inflation outlook and growth assessment, the impact on the currency market has been limited. The dollar is slightly higher across the board, but no new daily highs or lows have been achieved after the rate announcement. The rally in the dollar represents the market’s relief that that the Fed did not address the problems in the sub-prime sector. In fact, the Fed kept their comments on the housing market virtually unchanged. As for inflation, even though they acknowledged the fact that core price growth improved, they weren’t entirely convinced that the battle has been won. Instead, they still felt that inflationary pressures will refuse to fall. With oil prices hitting an intraday high of $70.52, the Fed has good reason to be worried. It should not be long before we see the national average of gasoline prices move back above $3 a gallon. The Federal Reserve really had no choice other than to keep the tone of the statement unchanged in order to tame the stock market bubble. For a comparison between the last two FOMC statements, see our Instant Insight. Although traders will be watching tomorrow’s PCE deflator for evidence of growing inflationary pressures, the more important releases will be personal income and personal spending. Should the gap between spending and income widen, then the US economy could seriously be in trouble, especially since the market is looking for the gap to narrow significantly. Beyond that, non-farm payrolls and service sector activity next week will provide traders with better clues on how the US economy is doing. For the time being, there is nothing to threaten the immediate trend of the US dollar.

Carry Trades Rebound as Profit Taking Comes to an End, Party Not Over Yet

Two days ago, we argued that the sell-off in carry trades represented profit taking rather than liquidation. Today, the strength of the rebound in the Yen crosses, particularly AUD/JPY, NZD/JPY and CAD/JPY confirm that it will take more than a mere correction to put an end to the carry trade. At the first sign of trouble, traders piled right back into their Yen short positions. Japanese industrial production dropped 0.4 percent in the month of May, the third consecutive monthly decline in manufacturing activity. Analysts were looking for very strong growth; expectations were for industrial production to rise by 0.9 percent, bringing the annualized pace of growth up from 2.2 percent to 4.8 percent. Although retail sales and the corporate service price index reported earlier this week were strong, the drop in industrial production may prevent the Bank of Japan from raising interest rates in July or August. Before rushing to judgment, it is important to wait for tonight’s Japanese economic releases. We are expecting CPI, overall household spending, the jobless rate, and manufacturing PMI. Whether Japan sees inflation or deflation will determine where the Yen is headed next.

New Zealand Dollar Hits 25 Year High as Strong Data Signals More Rate Hikes

The Australian, New Zealand and Canadian dollars were the strongest currencies of the day thanks the combination of higher commodity prices and the resurgence in demand for carry trades. New Zealand economic data also surprised to the upside with the first quarter current account balance narrower than expected, consumer confidence accelerating and building prices rising strongly. Money supply growth slowed slightly, but that did not stop Finance Minister Cullen from warning that the “economy is growing unsustainably fast” and “growing demand and incomes have created inflationary pressures.” Even though Cullen is not the head of the central bank (Bollard is), New Zealand government officials are clearly aligned when it comes to monetary policy outlook. Higher inflation and faster growth can only mean one thing, which is more rate hikes. New Zealand and Canada both have GDP due for release in the next 24 hours, so expect more active trading.

British Pound above 2.0 after Hawkish BoE Comments

The British pound broke above the 2.0 barrier following much stronger than expected house prices in the month of June. Originally expected to remain steady, house price growth doubled expectations. Next week, the Bank of England is set decide on interest rates and given recent economic data, there is a decent chance that the central bank will raise interest rates to 5.75 percent. Bank of England Governor King said this morning that the balance for inflation risks still remain on the upside and indicated that 25bp hikes will not do much to hurt domestic consumption. These are the words of a hawkish central banker which says a lot a week before an interest rate decision. Tomorrow we have the GfK consumer confidence report. No major changes are expected there as stronger retail sales and higher house prices offset weaker average wage growth.

Euro Sells Off Despite Stronger Labor Market and Inflation Picture

The Euro has sold off for the fourth consecutive trading day but the degree of the four day weakness pales in comparison to the typical moves that we are accustomed to seeing in the EUR/USD. Central banks like the ECB must be delighted with this lack of market volatility and as traders it has become the perfect currency to range trade. General interest in trading the Euro has waned according to the latest FXCM Speculative Sentiment index. Economic data released this morning was mixed. Even though the unemployment rate dropped in Germany and the retail PMI improved, a big drop in French retail PMI dragged overall Eurozone activity lower. Money supply was higher than expected, highlighting the inflationary pressures that the Eurozone still faces. German retail sales and French unemployment are due for release tomorrow. Spending is expected to drop after rising strongly in the month of April. However the improvement in the labor market and the rise in the IFO consumer survey suggest that another rise is not of the question.


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