NEWS / Monetary Policy

Forex: Dollar Rebounds as US Explores Diplomacy With Iran

DailyFX Fundamentals 05-31-06

By Kathy Lien, Chief Strategist of www.dailyfx.com

??? Dollar Rebounds as US Explores Diplomacy With Iran
??? Strong Eurozone Data Keeps Losses in Euro Limited
??? Mixed Reports Out of UK Exacerbate Losses

US Dollar

The door to the possibility of a resolution with Iran has opened ever so slightly as the US announced that they would be willing to join the European Union in talks with Iran if they suspend their uranium enrichment activities. Even though Iran has yet to show willingness to comply, this is the first diplomatic step by the US and according to Washington insiders, it represents a major shift in US policy. This has sent oil and gold prices tumbling and the US dollar rising. A possible resolution with Iran benefits the US economy in many ways. It reduces the upward pressure on commodity prices, which should curb inflation while at the same time giving consumers more breathing room as we head into the busy summer driving / travel season as well as the Atlantic hurricane season. However, we are still only skirting the surface of a possible resolution. Iran could reject the US??™ attempts at diplomacy, leaving us right back at square one. Meanwhile manufacturing activity in the Chicago region came in much stronger than expected, rising to 61.5 from 57.2, the strongest level in 7 months. This caught the market by surprise and was the primary catalyst for today??™s dollar rally as it suggests that tomorrow??™s ISM report could be equally strong. Meanwhile little direction could be gathered from the last Federal Reserve monetary policy meeting. Giving neither dollar bulls or bears much to work with, the Fed said that they contemplated everything from a pause to a 25 and even 50bp rate hike. They are still concerned about inflation and felt that core prices were a bit higher than expected, enough so that they even contemplated whether it would be appropriate to say that inflation expectations are still ???contained.??? Yet at the same time, they felt that given the uncertainty in terms of growth and inflation, it was difficult to tell ???how much, if any, further tightening would be needed??? after their May rate hike. The bottom-line is that the Fed is not sure what to do next with interest rates, which makes the next month??™s calendar economic data even more important because their June decision will truly be data dependent. With the probability of another rate hike in June sitting near 50 percent, either scenario is fair game at this point. The most important economic data due for release this week is non-farm payrolls. We have already mentioned that analysts are aiming high after being grossly disappointed last month. They are predicting that 170,000 jobs have been created this month. However, judging from smaller employment reports released today, analysts may once again find themselves a bit too optimistic. The Hudson employment index actually dropped 5.4 points in the month of May while the ADP private non-farm payrolls report rose 122k, which is 56k less than the previous month. This is clear indication that employment growth is decelerating which means that it would be surprising if non-farm payrolls buck the trend by reporting acceleration in job growth during the month of May. How non-farm payrolls turn out could be a key in determining the next direction for the EUR/USD.

Euro

The Euro is weaker today but weakness has been limited as stronger economic data and hawkish comments from Eurozone officials continue to keep the currency well supported. There were a lot of economic data released this morning and the majority surprised to the upside confirming the region??™s current strength. Economic confidence rose from 104.9 to a more than expected 106.7. Increased sentiment was seen in industrial, business and consumer confidence. This is partially related to the improvements in the labor market. Yesterday France reported a larger drop in the number of unemployed claimants. Today, Germany also reported a drop of 93k, which is over four times the amount the forecasted. This brought the unemployment rate down to 11 percent from 11.3 percent. Meanwhile German retail sales also came in stronger, rising 2.8 percent last month. The only damper to the day??™s positive news was the softer French producer prices and slightly weaker consumer confidence. Overall though, inflation pressures are still very strong, enough so that ECB member Hurley was tempted to say that ???the direction of interest rates is upward.??? Unlike the Federal Reserve, European central bank officials have been crystal clear with their plans on interest rates. The market never likes uncertainty which suggests that this divergence in transparency will certainly be more beneficial for the Euro.

British Pound

The British pound weakened against both the US dollar and Euro but the move against the dollar was more pronounced than the dollar??™s rally against the Euro. Unlike the European data which was mostly positive, UK data was mixed. Money supply growth accelerated, suggesting inflation pressures but mortgage lending and house price figures failed to meet expectations. The housing market is very important for the UK economy and has always been a major focus for the Bank of England. Consumer sentiment also already weakened slightly from -4 to
-5 which is also a bit concerning since domestic spending has been the primary fuel for growth. So far, the economic scorecard keeps the BoE solidly at neutral unlike the ECB who is solidly hawkish. This is a dynamic that should have a meaningful impact on EUR/GBP.

Japanese Yen

Once again, we have divergent price action. Today the Yen rallied against all of the major currencies except for the US dollar. Economic data was mixed with the purchasing managers??™ index falling in the month of May and total cash earnings less than expected. In contrast, housing starts were very strong, rising 15 percent while construction orders rebounded last month. It seems as if today??™s move in the yen is more a correction after yesterday??™s sell-off than true strength. Chinese Commerce Minister Bo also rejected calls for more currency revaluation, but talk that Chinese growth will continue to remain solid has neutralized the risk.