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Wednesday July 4, 2007 - 17:13:13 GMT -

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Forex - Strong Euro Will Play a Role in ECB Policy

DailyFX Fundamentals 07-04-07

By Kathy Lien, Chief Strategist of

• Dollar: Watch Non-Manufacturing ISM and ADP for Clues on Non-Farm Payrolls
• British Pound Hits Fresh 26 Year High, BoE Comments Hold Key to Further Strength
• Strong Euro Will Play a Role in ECB Policy

Dollar: Watch Non-Manufacturing ISM and ADP for Clues on Non-Farm Payrolls
Unsurprisingly, the markets have been extremely quiet with US traders off celebrating Independence Day. There has been little action in the foreign exchange market with the dollar strengthening only slightly against the British Pound and Japanese Yen, and weakening slightly against the Euro and commodity currencies. Although the interest rate decisions by the European Central Bank and Bank of England should be the most market moving events tomorrow, traders will also be looking closely at the Service Sector ISM and Challenger layoff reports as well as the ADP Employment survey. With many US traders taking the remainder of the week off, we could see more than usual volatility from this Friday’s non-farm payrolls report. Unlike the manufacturing sector, the expansion in the service sector is expected to slow but having reached the highest level in more than a year last month, even a small dip leaves service sector activity at a lofty level. Unless we get a very hawkish outcome from the ECB and BoE meetings, further dollar weakness should be limited because the inflationary pressures are far more pressing at the moment than growth concerns. Oil prices continue to remain above $70 a barrel while stock prices refuse to fall. Since the beginning of the year, crude prices have increased over 40 percent and if it continues to rise, we could see a sharp jump in both headline and core prices. For more on the ramification of $70 oil for the currency market, see our Special Report. The Federal Reserve will only shift away from their hawkish monetary policy bias by seriously considering lowering interest rates when job growth falls below 100k. If companies stop hiring, then the US economy is in serious trouble. That is why payrolls going forward will be extremely important because the stability of the housing market is hanging by a thread.

British Pound Hits Fresh 26 Year High, BoE Comments Hold Key to Further Strength
Interest rate announcements are always important for the foreign exchange market. With the Bank of England, this upcoming rate decision will be market moving regardless of whether they decide to raise interest rates or not. After having raised rates in May and then leaving them unchanged in June, the BoE is expected to lift rates to 5.75 percent tomorrow. Of the 60 economists surveyed by Bloomberg, 87 percent of them are calling for an interest rate hike. This almost unanimous view puts the “surprise” element of the event risk to the downside. The recent movement of the British Pound indicates that the currency market expects big things from the central bank. The only outcome that they would be satisfied with is a quarter point rate hike by the BoE followed by language that alluded to more rate hikes to come in near term. Anything else, meaning either unchanged rates or a more cautious statement would be a big disappointment that could lead to sharp weakness in the British pound. With the GBP/USD trading above 2.0, there is a decent chance that the central bank will move to a “wait and see” mode after lifting interest rates. Meanwhile despite a drop in consumer confidence, UK data remains strong. Service sector PMI increased from 57.2 to 57.7 in the month of June; the inflation component rose from a 15 month low.

Strong Euro Will Play a Role in ECB Policy
Having just raised interest rates last month, the European Central Bank is expected to make no alterations to monetary policy tomorrow. Although this means that the 7:45am EST announcement will be a non-event, the 8:30am EST press conference could be very market moving. As usual, central bank President Trichet will be shedding more light on what they plan to do with interest rates in the months ahead. Like the UK, the Eurozone faces inflationary pressures that warrant higher interest rates, but the strong level of the Euro may give the central bank the flexibility to wait until after the summer to raise rates. They may not want to risk sending the EUR/USD to 1.40 by raising rates prematurely when the strong currency will automatically help to reduce inflationary pressure. This morning’s Eurozone data was mixed. Eurozone service sector PMI was stronger than expected in the month of June which combined with the strong manufacturing data, is very encouraging. Retail sales however fell short of expectations, but that was expected given weakness in German consumption.

RBA Leaves Rates Unchanged, CAD IVEY PMI Could Cement Bottom in USD/CAD
The Australian, New Zealand and Canadian dollars rebounded thanks to stronger economic data and steady oil and gold prices. Even though the Reserve Bank of Australia left interest rates unchanged at 6.25 percent and the country’s Service Sector PMI index dropped from 56.1 to 54.9, the sharp improvement in the trade balance caught the entire market by surprise. The market was looking for the deficit to increase from -916M to -1.2B, but instead it decreased to -807M. Despite the strength of the Australian dollar, export demand increased in the month of May. The details of the report indicate that the export growth was mostly due to demand from the Middle East because demand from the US actually dropped due to the rising Australian dollar. Canadian building permits and IVEY PMI are due for release on Thursday. The risk is to the downside for both reports given recent weakness of data.

Carry Trades Rebound Despite Possible Upgrade by Moody’s
Demand for carry trades continues to remain strong with EUR/JPY a hair shy of hitting a new record high while both AUD/JPY and NZD/JPY are rallying back towards their decade highs. Stock markets around the world are up which means that risk aversion continues to remain low. This is further confirmed by the fact that the Thai Baht, which is a high risk currency hit a new 10 year high. There was no economic data released from Japan overnight but rating agency Moody’s said that they are considering upgrading Japan’s sovereign debt rating. They felt that the economy is at an “inflection point” and they will be watching closely for further improvements in growth. Yen traders have completely shrugged this off. Leading indicators are due for release tomorrow and they are expected to improve.


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