FXCM - Counting Down to FOMC - Dollar Bulls Still in Control

DailyFX Fundamentals 06-23-06

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

- Counting Down to FOMC ??� Dollar Bulls Still in Control
- Record High in Belgian Sentiment Index Signals Possible Strength in German IFO
- Busy Week Ahead for Japan

US Dollar

As we head closer and closer to the Federal Reserve??�s end of June monetary policy meeting, the US dollar has continued to gain strength. The clear monetary policy divergence between the US and many other countries around the world such as the UK and Japan has benefited the US dollar significantly. However whether this benefit can be sustained will be contingent upon the tone that the Fed sets for the weeks ahead. Many traders believe that 5.25 percent rates, which includes the upcoming hike will be the highest that the Fed will go, but there are also a small number of analysts calling for 6 percent rates, suggesting that the Fed could continue their tightening cycle until October. If they are still tightening in September, this would already overshoot the expectations of most traders, which means that position adjustments could push the dollar even higher. As of Friday, the market has fully priced in a quarter point rate hike. The forecast for another dose of tightening in August is now also above 50 percent. Therefore quite a bit of volatility could stem from the FOMC statement due for release on Thursday regardless of whether the central bank alters its tone. Typically we get some quiet market activity prior to the FOMC meeting, but this time, things could different. We start the week off with the new home sales report followed by consumer confidence on Tuesday. Both pieces of data will shed more light on how much damage the previous rate hikes have done to the economy and help traders position themselves for the rate decision. Weak housing and consumer confidence numbers could mean that the economy as a whole may not be strong enough to handle another 50 to 100bp of tightening while stronger numbers may give the Fed??�s hawkish stance more validity. The only piece of US data released today were durable goods orders for the month of May. The headline number was weak with total orders falling by 0.3 percent, but the components were not as pessimistic as orders excluding transportation rebounded by 0.7 percent.

Euro

Broad dollar strength pushed the Euro lower despite some rather good news. The Belgian survey of manufacturing confidence soared to a record high of 10.6 from 1.4. Although the index represents sentiment in a very tiny country, it tends to be correlated with the German IFO survey and such a big jump in general is one worth noting. This suggests that next week??�s IFO report may not be as bad as analysts are expecting. Of course, the Belgian index is far more volatile than the German index, but today??�s number is certainly encouraging. Meanwhile, European Central Bank council member Weber reiterated that vigilance was needed when dealing with inflation risks. He is one of the most hawkish members of the central bank and the only one to use the word ???vigilance??? since the last monetary policy meeting. Therefore even though this is a key word in central bank speak to relay a bias towards raising interest rates, his view holds less significance than if it would have come from ECB President Trichet or another more dovish member of the central bank. It is no question that the central bank still plans on raising interest rates later this year, but most members have been quiet as they review incoming data. The next rate hike where interest rates will probably be changed is not until August, therefore the ECB probably feels no need to prematurely change the sentiment in the market. In all likelihood, they are probably quite pleased with the level of the Euro at the moment. The prior rally above 1.29 posed a risk of hurting growth so the ECB picked the simplest way to talk down the Euro. Now that it is at more comfortable levels, they probably want to enjoy it for as long as possible.

British Pound

The British pound extended yesterday??�s massive losses as fundamentals and technicals both called for further weakness. There was no significant data released today so the market continued to sell the pound on speculation that the Bank of England will be delaying any potential interest rate hikes following the death of monetary policy committee member Walton. In the meantime, they will probably be focusing on looking for replacements for the two open posts on the committee. There are a handful of UK data worth watching in the week ahead. This includes housing market figures and GDP on Friday. None of the data should shift the BoE??�s stance by much which means that the value of the British pound will probably be driven by the US dollar component of the pair.

Japanese Yen

After weakening significantly yesterday, the Japanese Yen rallied against most of the majors except for the US dollar. Comments from Yu Yongding, a Chinese central bank advisor helped to rally the Yen. He said that China could accelerate its Yuan appreciation and tighten monetary policy due to the rapid growth in foreign investment. As we get closer to the 2008 Olympics, further Yuan appreciation becomes more likely. However controversy surrounding Fukui resignation is capping any gains in the Yen. Even though the government continues to stand behind Fukui and most recently, he reiterated his plans to complete his term as BoJ Governor, two public opinion polls indicate that nearly half of the voters polled were calling for Fukui to step down. If so, this would be a huge loss for the Japanese government as well as the negative for the Japanese Yen since he was one of the biggest advocators of removing the country??�s zero interest policy sooner rather than later. In the week ahead, politics could continue to dominate the headlines as North Korea remains a risk, but economics will also be important given the long list of economic releases. We are expecting retail sales, industrial production, the trade balance, small business confidence, household spending, unemployment, CPI and housing starts.