NEWS / Fiscal Policy, Budget

Forex - Dollar Weakens as Softer Beige Book Keeps a Fed Pause on the Table

DailyFX Fundamentals 07-26-06

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

??? Dollar Weakens as Softer Beige Book Keeps a Fed Pause on the Table
??? No Interest Rate Hikes Expected in New Zealand
??? BoJ Official ??“ Another Rate Hike in 2006 Not Out of the Question

US Dollar

Rarely is the Beige Book report as market moving as it was today. At a time when traders are scrambling to figure out whether the Federal Reserve has enough evidence to raise interest rates again in August, the clarity of the Beige Book was exactly what dollar bears needed to hear. The problem with yesterday??™s reports was that existing homes sales is too backward looking while the Confidence indicator conflicted with recent retail sales reports. The Beige Book report is more reliable because it explains the current state of the economy and the risks that it faces. Analysts have been worried about consumer spending and housing and today??™s Beige Book report confirmed those fears. According to the Fed districts, there have been continued weakness in retail sales and except for ???only scattered exceptions??? activity in the housing market is also slowing. Inflation pressures or increases in the prices of final goods and services have also remained modest. However even though the report is clearly more supportive of a pause than a hike, do not be mistaken, the report indicates that economy is still growing and that there has been significant activity in commercial real estate sales and industrial sector activity. Whether today??™s dollar weakness can be sustained will be dependent upon tomorrow??™s durable goods and new home sales reports. Stronger demand for aircrafts and the replacement of older equipment for newer energy efficient equipment is expected to boost sales but given the recent trend of the economy and the weakness seen in the previous month, the rebound could fail to meet expectations. In addition new home sales will also be important because it is a more current reading than existing home sales and a better reflection of the state of speculator driven housing market bubble. Many builders have already reported a decline in sales and increase in inventories, which are expected to be reflected in tomorrow??™s report. Over the past two days, traders have accentuated the negative and minimized the positive when it comes to US data ??“ we expect the same reaction tomorrow.

Euro

The German ZEW and Belgian manufacturing survey correctly forecasted today??™s drop in German business confidence. The IFO report eased off 15 year highs to fall from 106.8 to 105.6 in the month of July. Although the drop was more than expected, it still remains at an extremely strong level, especially since the last time the index was above 105.6 was in 1991. The expectations component also fell less than expected to 102.6 from 104.2. Overall, this is a good start to the third quarter for the German economy and continues to support the case for another interest rate hike from the European Central Bank on August 3rd. Beyond that, we will need to be more reactive to the comments from ECB officials. The upcoming hike in the VAT tax from 16 to 19 percent along with high oil prices could pose a risk to further economic growth. Yet, for the time being, as we continue to see economic data that has been impacted by the World Cup, traders may push off this fear unless Trichet reintroduces it at the press conference following the monetary policy meeting. Both the French employment report and the German confidence report are expected to be strong tomorrow and would aid in any EUR/USD extension move off of weaker US economic data.

British Pound

The British pound continued to climb higher today despite the fact that the CBI??™s industrial orders survey improved less than expected. The index shrank from -12 to -11 versus the market??™s -10 forecast. The quarterly business sentiment survey also fell from -2 to -6 in the second quarter, against expectations for an improvement to zero. Even so, over the past two weeks, we have seen mild improvements in the economic health of the UK economy. Yet, mild improvements will not be enough to prompt the Bank of England to raise interest rates in August which means that the divergence between their monetary policy stance and the ECB??™s stance will be increasingly clear. In fact, we are already seeing a recovery in the EUR/GBP. With no more UK data scheduled for release this week, there could be scope for a further recovery in the cross as traders hone in on the two country??™s fundamentals.

Japanese Yen

The performance of the Japanese Yen was very mixed against the majors, but the outlook for the country??™s monetary policy is not. Bank of Japan monetary policy member Suda said today that he believes interest rates need to adjust ???in a way that isn??™t behind the curve??? and added that it is not of the question for the central bank to raise rates again in 2006. Given that Suda is one of the more hawkish members of the BoJ, his comments are not extremely surprising. However, it does validate the possibility that their use of the word gradual is similar to the Fed??™s use of the word measured. If so, the BoJ could deliver another interest rate hike in the fourth quarter, after the market has fully absorbed the last rate hike and has begun to quietly price in another one. Meanwhile Japan??™s trade surplus increased from Y382 billion to a slightly less than expected Y807 billion. Exports experienced double digit growth for the eight straight months, fully offsetting the increased oil contribution to import values. China continues to remain on our radar screens as the possibility of another revaluation move grows. China??™s Chief Economist of the State Information Center said last night that the best way to ease the trade surplus is through an appreciation in the Yuan. Finally, the Reserve Bank of New Zealand is expected to keep interest rates on hold tonight at 7.25 percent. With slowing economic growth, it is unlikely that the central bank will move on interest rates any time soon. Like the EUR/GBP, the divergence in the monetary policy of Australia and New Zealand has also become increasingly clear, leading to a strong recovery in AUD/NZD. The Reserve Bank of Australia is now expected to raise interest rates by 25bp in August.