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Forex - Dollar Rallies as Recent Fed speak Hint at Hawkish FOMC Statement

DailyFX Fundamentals 10-23-06

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

??? Dollar Rallies as Recent Fed speak Hint at Hawkish FOMC Statement
??? Japanese Officials Shrug Off Concern about Yen Value and Carry Trades
??? Strong PPI Raises the Possibility of an RBA Rate Hike in November

US Dollar - Traders have bid up the US dollar as the stock market continues to power ahead and oil prices continue to fall. The lack of any meaningful US economic data today and for the most part tomorrow as well has most traders already looking ahead to Wednesday??™s Federal Reserve rate decision. Interest rates are set to remain at 5.25 percent, but as we explored on Friday, the main focus will be on whether the central bank puts greater emphasis on the drop in headline inflation or the rise in core prices. It seems that the markets have already made up its mind about which way the Fed will swing. The rally in the US dollar suggests that the Fed will opt to focus on the sustained strength of core price inflation on both the consumer and producer level, which represents slightly hawkish comments. The odds are certainly in favor of this possibility as Fed official after Fed official has warned about inflation since the beginning of the month. Starting with Hoenig who is a non-voter, he characterized the current level of core inflation as too high. Fed Vice Chair Kohn said that the upside risks to the outlook for inflation warrant continued vigilance while Philadelphia Fed President Plosser and Richmond Fed Lacker hinted that policy may actually need to be firmer if core inflation continues to remain at current levels. Even Fed Chairman Bernanke said that inflation is still above what they would consider price stability. The comments range from cautiously hawkish to very hawkish with no one we have heard of late shying on the side of dovishness. When central bankers speak, we listen and their recent message has been quite unanimously clear. However we do want to point out that hawkish comments will not open up the risk for a rate hike. Instead, it will simply keep on the Fed on hold for a longer period of time with the market bias still looking for a rate cut before a hike as the next likely policy change.

Euro and Swiss Franc - The Euro has given back most of Thursday??™s impressive gains as the market looks ahead to an interest rate meeting in US later this week. ECB officials continue to stand firm with their plans on raising their own interest rates again later this year. ECB member Wellink was the latest central banker to add fuel to fire as he said that the central bank ???won??™t deny??? the market??™s expectations for a December rate hike. Like most other ECB officials, he feels that interest rates still remain very low. The recent weakness in the Euro will make it even easier for the ECB to raise rates. We are once again moving close to the 1.25 support level in the Euro. It has held strong throughout the beginning of this month and we believe that it will take a lot to push the pair through it. However, the FOMC statement is a powerful one and extremely hawkish comments could be the catalyst that Euro bears have been waiting for. It can even diminish any bullishness that may come off of a stronger German IFO report. Should the IFO be weak however, expect a sell-off in the Euro to be exacerbated. The Swiss franc also sold off today, against both the US dollar and the Euro. There is no Swiss data until later this week but the market expects the sole KoF leading indicator report to have fallen in the month of October, which would be in line with the recent strength that we have seen in EUR/CHF.

British Pound ??“ Broad dollar strength has also hit the British pound which has had an exceptionally good two weeks. Despite the lack of significant UK data this week, the strong GDP and inflation reports should continue to resonate in the market. Traders are looking for the Bank of England to resurrect its rate hikes later this year, but the CBI manufacturing and distributive trade surveys are the only pieces of data that we have this week to confirm or deny that. This means that the only thing we have good confidence in is the fact that GBP/USD will put up a good fight with the Euro and as a result, EUR/GBP may be set for more range trading.

Japanese Yen ??“ Although supermarket sales was the only piece of data that we had from Japan last night, there was some interesting comments from Japanese officials. Watanabe from the Ministry of Finance said that inflation remains weak and even though the yen has fallen significantly against both the Euro and US dollar since the beginning of the year and is sitting near its year to date lows against both, he does not feel that it is currently weak. This signals that the Japanese government is not about to consider intervening to strengthen the yen and essentially feel that exchange rates will eventually correct themselves. We doubt they will feel the same if this was yen strength that we are talking about instead of yen weakness. In regards to carry trades, Watanabe says that they size and impact has been over exaggerated which also suggest that they are not worried about it at the current moment. With the Japanese government not standing in the way of further yen strength, we have already seen AUD/JPY hit a 10 month high and we would not be surprised to see other yen crosses also continue to rally.