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Forex - Dollar Bulls are Positioning for Hawkish FOMC Statement

DailyFX Fundamentals 10-24-06

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

??? Dollar Bulls are Positioning for Hawkish FOMC Statement
??? ECB Members Suggest that Monetary Policy Beyond 2006 is Unclear
??? CPI to Decide Whether RBNZ Will Raise Interest Rates to 7.50 Percent

US Dollar

Tomorrow will be the make it or break day for the US dollar as both the Euro and Japanese Yen trade within an arm??™s reach of 1.25 and 120 against the US dollar. Yesterday, we explored the most likely outcome of the Fed meeting and concluded that given recent comments from Fed officials, they are far more likely to be concerned about inflation than economic weakness and the statement should reflect that. In fact, Lacker may not be the only voter to favor a rate hike in the month of October. However, with consumers stretched thin, the manufacturing sector languishing, the surprise drop in the Richmond Fed business activity index, mid-term elections around the corner and the possibility of declines in the housing market, an actual rate hike tomorrow is nearly impossible. Yet, even if the FOMC statement is hawkish, the main question will be whether there are enough buyers out there to continue to take the US dollar higher. Implied dollar positions based off of Friday??™s COT report indicate that dollar longs are now at the highest level since December 2005. We have often said that 1.25 has proven to be rock solid support in the EUR/USD, but we do not talk enough about 120 in USD/JPY. Central bank comments from around the world have frequently surfaced when the currency pair nears that level and we suspect the same will happen if we head there once again. It hasn??™t been that long since Russia said they were buying yen. Unfortunately, the potential impact of the Fed meeting is most likely overstated and even if we do see a dollar rally, the rally could be limited to 60-70 pips for each currency pair ??“ which would not be enough to spark a meaningful up tick in FX volatility. The predictability of central banks has pushed volatility towards its record lows, but whenever this happens, there is always something that comes out of the left field to wake the market up.

Euro and Swiss Franc

The Euro has rebounded against the US dollar, but with two major event risks on tap tomorrow, one in Germany and one in the US, the rally is most likely attributed to profit taking and position squaring than anything else. Today??™s surprise weakness in the Belgium manufacturing survey suggests that business sentiment should also have pared back in Germany, which would be in line with the negative reading in the ZEW survey reported last week. A similar case is expected in France and Italy as all three indexes retrace from higher levels. The larger than expected drop in consumer spending in the month of September may have even had a more damaging effect on French confidence than the market is currently forecasting. Even though one more rate hike is expected from the European central bank this year, ECB officials are beginning to play down the possibility of more hikes after that. Gonzalez Paramo said that more information is needed before they can decide what to do with interest rates in 2007. Quaden made a similar comment when he said that talking about 2007 rates is a bit premature. Of course, a lot can change over the next few months, but for the time being, we are seeing evidence that the ECB??™s next rate hike may be their last. Meanwhile the Swiss Franc is under slight pressure today after comments from SNB President Roth. Even though Roth reiterated the central bank??™s plans to continue tightening interest rates and believes that growth is still strong as well as favorable for the Franc, the fact that he said gradual tightening is needed eradicates the possibility of a 50bp hike in December.

British Pound

Despite the sharp drop in the CBI manufacturing survey from -5 to -20, hawkish comments from the Bank of England??™s monetary policy committee has helped the British pound hold above the 1.8700 level against the US dollar. The manufacturing sector is still fragile, but that has not stopped the central bank from considering raising interest rates. Charles Bean said today that it is best to ???err on the side of caution against inflation.??? Like his peers around the world, he believes that core (or non-energy) inflation is still persistently high and that warrants caution by the central bank. Bean is not the first that we have heard such comments from. The minutes from the October meeting indicated that Tim Besley and Andrew Sentance voted in favor of a rate hike earlier this month. Even Mervyn King noted two weeks ago that the declines in September inflation were most likely temporary. Therefore another rate hike in November may not be completely off the table.

Japanese Yen

The Japanese Yen continues to remain weak as it awaits direction from the US rate setting committee. Oil prices are marginally higher which may have contributed to the slide against pairs like the Euro, Aussie, Canadian dollar and British pound, but for the most part, central banks continue to cap gains in the Yen crosses. The longer the Yen remains weak, the more beneficial it will be for the Japanese economy. Tonight??™s trade balance report should already reflect an improvement in exports. Tomorrow the yen should take a back seat to the action in the rest of the world.

Commodity Currencies (CAD, AUD, NZD)

The Canadian dollar has rallied strongly against the US dollar thanks to a new round of acquisition news and some month end repatriation by Canadian oil and gas producers. Although no data is set for release tomorrow, Bank of Canada??™s Dodge and Jenkins will be talking about the economy sometime tomorrow. In the world of the commodity currencies, Australia and New Zealand should be the day??™s bigger focus. Both countries will be reporting consumer price data with decelerations in price growth expected in both though the risk is to the upside given the strong PPI report from Australia on Monday. New Zealand will also be announcing an interest rate decision at 4pm EST on Wednesday. The decision will be close. Even though the Bloomberg consensus calls for no changes, analysts are split 50-50 on a chance for a quarter point hike. Tonight??™s CPI data will be the early clue on how the RBNZ will swing.