NEWS / Trade Policy

Forex: Stronger Housing Data Validates Fed's Planned Rate Hike

DailyFX Fundamentals 06-26-06

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

??? Stronger Housing Data Validates Fed??™s Planned Rate Hike
??? Euro Rallies as Traders Expect Stronger IFO Survey
??? Yen Traders Nervous as Possibility for Fukui Resignation Grows

US Dollar

The US dollar is slightly weaker today, but for no reason other than continued consolidation. With less than 3 days until the FOMC meeting, traders are managing their positions cautiously as this week??™s meeting could prove to be one of the more volatile meetings that we have seen in months. Widely expected to deliver their seventeenth consecutive interest rate hike, expectations of what the Fed will do or say is exceptionally diverse. Most analysts are expecting a quarter point interest rate hike but are divided on the tone of the accompanying FOMC statement. Will the Fed be exceptionally tough, or relax their strong stance on inflation? It is irrefutable that the US economy is slowing from its torrid pace of growth but with everything hinging upon housing, the fact that the housing market has yet to crash is still giving the Fed a good excuse to continue to tighten. This is especially true since new home sales increased by 1.23 million last month. This is much stronger than expected considering that the market was calling for a drop in new home sales. Even though there was a downward revision to the April data, the surprise in May more than offsets that. Prices did fall slightly, which could have helped increase sales, but no matter which way you slice it, today??™s report is strong. If tomorrow??™s existing home sales report confirms the strength in new home sales, the dollar could easily shake off today??™s weakness to gun for another test of 1.2500 against the Euro, especially if consumer confidence comes out in line or stronger as well. There has been some mild speculation that the Fed may opt to tighten by a more aggressive 50bp instead of 25bp. The possibilities for this are miniscule since a 50bp hike would deliver significant volatility to markets that are already jittery. It would send stock prices tumbling and put to question Bernanke??™s credibility as the market wonders if he has contemplated the dangerous ramifications of overshooting interest rates. We think that in the most likely scenario, the Fed will hike by 25bp and leave the statement mostly unchanged to give themselves the flexibility to adapt their next move to the trend of economic data. Should data begin weaken, they can always soften their tone between meetings.

Euro

With fundamental support, the Euro has bounced off of the psychologically important 1.25 level. Last week we had said that Weber was the only member to take on a significantly hawkish tone since the last European Central Bank meeting and since he is usually more hawkish than his peers, his words had less significance. This morning however, he was joined by ECB council members Mersch and Quaden. Mersch hinted that the ECB could be more aggressive with rate hikes and may even opt for an inter-meeting hike if inflation pressures continue to grow. He even introduced the possibility of raising rates by 50bp if needed. Quaden was equally hawkish when he said that the central bank was keeping open the possibility of an earlier than expected rate hike. These are very hawkish comments and if we hear the same from other ECB officials over the next few weeks, particularly if they are from ECB President Trichet, the Euro will certainly be putting up a good fight to stay afloat against the dollar. Meanwhile tomorrow we are expecting the German IFO survey. There has been much talk that the IFO survey could be stronger following the sharp rise in the Belgian business survey. Businesses have remained far more optimistic than analysts have been and even though the Belgian index is a tiny and more volatile one, it is widely watched. With the World Cup being held in Germany, businesses have a good reason to be a bit more optimistic. Business confidence in France slipped but unlike Germany, they do not have the benefit of hosting the World Cup. Inflation numbers were also supportive of today??™s Euro rally. Consumer prices in Germany increased by a more than expected 0.2 percent this month. The biggest surprise however came from Switzerland. They reported a 12.2 percent jump in retail sales in the month of April. This far exceeded the market??™s forecast for a 7 percent rise and paves the way for another rate hike by the Swiss National Bank.

British Pound

Led higher by Euro strength, the British pound also bounced today. The only piece data released from the UK was hometrack prices for the month of June. According to the survey, prices rose by 0.6 percent, which was the fastest rise in 2 years. This suggests that the UK housing market is rebounding nicely thanks to the central bank??™s solidly neutral stance. With the surprising death of Walton, the Bank of England will probably opt to delay any changes to monetary policy for the time being. This will help the housing market rebound further and allow the UK economy to recover smoothly. Tomorrow we have more housing market data due for release and judging from the market??™s forecasts, it should also be supportive for the British pound.

Japanese Yen

The performance of the Japanese Yen has been very mixed today as the market continues to contemplate the possibility of a resignation by Bank of Japan Governor Fukui. Clearly the central bank governor does not want to resign and the government wants to keep him on as well, but the country??™s four leading opposition parties have all joined forces to call for his resignation. Public opinion has turned against him and according to the Times of London, Fukui only stands a 50-50 chance of keeping his job this week. If he is really forced to resign, it would be extremely yen bearish since Fukui is seen as one of the market??™s most respected central bankers. In addition, we have often said that he is one of the market??™s biggest cheerleaders for the removal of the country??™s zero interest rate policy. If he does resign, it could delay any eventual removal for months if not years.