Forex: Traders Dump Dollars on Rising Oil Prices and Upcoming ECB Meeting

DailyFX Fundamentals 08-01-06

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

??? Traders Dump Dollars on Rising Oil Prices and Upcoming ECB Meeting
??? Euro at 1.29 Could Make ECB Uneasy
??? Bank of Japan Hints of Another Rate Hike by Year End

US Dollar

There is always more than meets the eye when it comes to the US dollar. Stronger economic data and dollar supportive comments from new US Treasury Secretary Paulson helped to rally the dollar for only a brief moment before the gains were completely erased at the London close. Increasing tensions in the Middle East and a tropical storm brewing near the oil refineries in the Gulf of Mexico has traders worried that oil prices could hit a new record high over the next few weeks. With temperatures heating up around the US and the possibility that a new national record will be set in July for the warmest month since 1895, energy usage is sure to be reaching extreme levels. This means that utility bills for many families across the nation will be painful for the month of July and possibly even August. Combining this with high gasoline prices and increasing mortgage payments, traders are continuing to accentuate the negative and minimizing the positive when it comes to outlook for the US economy. Conflicts in Lebanon have yet to ease while Iran rejected the UN??�s calls for an end to their nuclear development program by the end of the month. Without even attempting to try to delay international outrage, Iran has branded the UN Security Council??�s resolution as worthless while a high level Iranian official said that ???Iran will not take part in a game which it will lose.??? The only barrier standing between the EUR/USD and 1.30 is the possibility of another rate hike by the Federal Reserve next week. Inflationary pressures continue to remain very strong with the annualized core PCE deflator, which is one of the Fed??�s favorite inflation barometers hitting a four year high last month. The growth of key core prices increased by 2.4 percent over the past year, which marked the third straight monthly rise. After Friday??�s disappointing GDP numbers, a quarter point rate hike is now back on the table. This is especially true following the increase in the ISM manufacturing index and the prices paid component for the month of July. In June, personal income and personal spending continued to rise with income outpacing spending. Finally, pending home sales and construction spending were also strong in the face of expectations of a decline. Yet, despite all of today??�s positive US data, the increasing tensions in the Middle East and the prospects of a rate hike by the European Central bank on Thursday has prevented the dollar from sustaining its gains. However, at the same time, the higher the Euro climbs, the more difficult each penny rise will be.

Euro

The Euro is now coming within an arm??�s length of its 12 month high of 1.2980, which it hit at the beginning of last month. The Euro has been rallying as another dose of decent Eurozone economic data continues to confirm the market??�s predictions for a quarter point interest rate hike by the European Central Bank on Thursday. However, if the Euro does continue to rally and hits 1.2900 before the ECB meeting, the central bank may rethink the message that they plan on sending to the market. We have long said that the value of the Euro is a key determinant of how aggressive the ECB plans to be with interest rates. As an export dependent economy, the stronger the Euro, the more pressure it has on the export sector. Talking up future rate hikes with the Euro at current levels could easily push it above 1.30. This would not be the first time that ECB President Trichet or his constituents used verbal intervention to stem the Euro??�s rise. The central bank could easily unload some of the upside pressure on the Euro by toning down his comments at the press conference following the meeting by being ambiguous about another rate hike over the next few months. This possibility is very real, especially with many other central banks having already slowed down or ended their own tightening cycle. The ECB may want to adopt a wait and see approach after this week??�s hike and take a back seat to watch what the Federal Reserve does with its own monetary policy next week.

British Pound

The British pound has rallied against the US dollar for the fifth consecutive trading day. Such a long stretch of continuous pound strength has not been seen since August of 2005. Despite a drop in the outlook for the UK manufacturing sector for the month of July, traders latched onto the rise in house prices as well as broad dollar weakness. Nationwide house prices increased by 0.8 percent in the month of July, which were double market expectations. The improvement of the housing sector is sure to be comforting the Bank of England as the country continues to stabilize. Even though the manufacturing sector PMI index fell from 55.0 to 53.8, the index remains in expansionary territory. The details are not as cleanly optimistic with the output and new orders components taking a sharp dive. For the time being, this should give the Bank of England good reason to keep their interest rates on hold at least until the fourth quarter.

Japanese Yen

The Japanese Yen continues to remain strong against the US dollar but gave back some of its recent gains against the Euro, Swiss Franc and British pound. Comments from Bank of Japan Governor Fukui indicate that the trajectory of interest rates is undoubtedly upwards. Following comments from monetary policy member Suda last week, Fukui said today that the central bank is not ruling out the possibility of another interest rate hike by the end of the year. Fukui warned that a prolonged period of excessively low interest rates could overheat the corporate sector. We still believe that the BoJ could raise rates later this year, especially after they have given the markets two to three months to absorb their first interest rate hike. The Japanese are known to be conservative and they are expected to approach monetary policy in the same way. Gradual rate hikes with plenty of advance warning and then time for the economy and the market??�s to absorb the hikes will probably be the best way to go for a country that has no interest in inducing a rapid appreciation in their currency. Remember, Japan is also an export dependent nation that always has one eye on the yen and its impact on the export sector.