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FXCM - Euro Retains Upper hand as Fed Draws Rate Hikes to a Close

FXCM - DailyFX Fundamentals 08-08-06

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

??? Euro Retains Upper hand as Fed Draws Rate Hikes to a Close
??? Improving Economic Data Helps to Extend Pound??™s Rise
??? Weaker Economic Data Weights on the Japanese Yen

US Dollar

Whether you realize it or not, we have just seen a major shift in the Federal Reserve??™s monetary policy. For two straight years, the central bank delivered back to back interest rate hikes that brought the federal funds rate from 1.00 percent to 5.25 percent. After 17 consecutive quarter point hikes, the Fed has decided to leave interest rates unchanged at 5.25 percent. Barring any unforeseen shocks to the US economy or the oil market, rates should remain at that level for the rest of the year. However, many traders may be scratching their heads wondering if that is really true, why would the weakness in the US dollar today be so limited? The answer is simple and that is because the market is confused. Just take a look at the sharp volatile moves that we saw in the EUR/USD immediately after the FOMC rate decision. Yes, the Fed paused, which was the scenario that we favored, but the confusion lies in their inclusion of the phrase ???additional firming may be needed??? if there are upside risks to inflation in their FOMC statement. Yet think about it ??“ this line had to be included. No one knows how much longer oil prices will remain high. British Petroleum??™s Alaskan oil fields could remain shut down for as long as two months while the National Hurricane Center forecasts seven to nine hurricanes this season of varying degrees. If we have one severe hurricane while the Alaskan oil fields are shut, crude prices could easily skyrocket above $80. Unless Bernanke can convince President Bush to release the country??™s strategic oil reserves, the Fed has no control over the path of oil prices. So to cover the ambiguous risks, the Fed is left with no other option than to leave themselves flexibility if needed. However, unless we have a serious shock, it is unlikely that Bernanke will risk his credibility and change his mind once again by lifting interest rates, which leaves the overall outlook for the US dollar still bearish. Furthermore, the Fed made zero mention of the sharp 4.2 percent rise in unit labor costs or the 1.1 percent rise in productivity, indicating that their main focus is on growth and not inflation. In fact, they fear that the lagged impact of their rate hikes and higher energy prices will restrain the country??™s already weak US consumer spending. A closer read into the report suggests that they actually toned down their inflation outlook by predicting a moderation in the months to come. Some bulls may argue that for only the second time in three years, the decision was not unanimous with one member voting in favor of an interest rate hike. However, one is far from a majority and Lacker??™s dissenting vote will quickly be forgotten. The EUR/USD??™s failure to push above 1.29 today makes 1.30 an even more difficult target to take out. With US interest rates still very high, the odds are weighted more towards a gradual slide than an all out collapse in the dollar.

Euro

The Euro has benefited from the Federal Reserve??™s decision to leave interest rates unchanged and we expect this to continue to give the single currency the upper hand. Since last Thursday??™s interest rate hike from the European Central bank, monetary policy officials have continued to talk up the need for more rate hikes over the next few months. With the Fed ending their tightening cycle and the ECB pressing forward, the interest rate differential between the US dollar and Euro will begin to compress towards the EUR/USD??™s favor. Unless the European Central Bank decides to make a 180 degree turn and stop setting the market up for an interest rate hike, we continue to expect more gains in the Euro. We do caution however that a pause from the Fed makes it easier for the ECB to delay future rate hikes. Economic data is beginning to turn sour suggesting that the central bank will forgo an interest rate hike at the end of month and instead raise rates in September at the earliest. The German trade surplus increased slightly more than expected in the month of June, but remember, June included the World Cup and data going forward may not be as promising. In fact, surprisingly, German industrial production actually fell 0.4 percent in June, bringing the annualized pace of growth down from 6.0 percent to 4.6 percent. Meanwhile Italian industrial production also grew by a much weaker than expected 0.1 percent in June.

British Pound

Like the Euro, the British pound benefited significantly from the dollar??™s weakness after the FOMC rate decision. However, unlike the Euro, the gains in the British pound were much stronger gains than the Euro??™s thanks to the unambiguously strong UK economic data. Total retail sales as measured by the BRC increased at an annualized pace of 6.1 percent in the month of July compared to 4.7 percent the month prior. The NIESR also upped its second quarter GDP estimate from 0.6 percent to 0.8 percent while building society Nationwide increased its forecast for house price inflation in 2006 from 3 percent to 5 percent. There continues to be signs of improvements in the UK economy which is the main reason why EUR/GBP remains under pressure. Also, the gap between US and UK interest rates are far narrower than the spread between Euro and US interest rates. If the Bank of England decides to raise rates again, the US-UK gap would be closed much faster.

Japanese Yen

The Japanese Yen is under pressure today after the country??™s man on the street Eco Watchers survey came in far weaker than expected. Originally forecasted to rise from 49.1 to 51.0, the index dropped to 48.4. The outlook component also fell from 51.8 to 49.8, indicating that the optimism has turned into pessimism. With oil prices on the rise, the Japanese economy stands to suffer. This gives the central bank good reason to leave interest rates unchanged at its August 10 to 11 monetary policy meeting. Even though officials from the central bank continue to call for more rate hikes, they are not expected to deliver any until the fourth quarter at the earliest. The Japanese economy is still gradually improving but not enough for the BoJ to take any aggressive measures.