NEWS / Foreign Exchange

Australia Raises Interest Rates, AUD Headed to Parity

• ECB??™s Only Option is to Be Hawkish

• US Dollar Continues to Weaken as Banking Sector Turmoil Raises Rate Cut Expectations

Australia Raises Interest Rates, Another Reason to Hit Parity
The Reserve Bank of Australia increased interest rates for the second time this year to 6.75 percent. This is the first time ever that the central bank has increased rates when an election is underway. This unprecedented move highlights the degree of inflation pressures the economy faces at the current moment. Comments from the RBA were relatively hawkish; they said that demand and output growth has increased and they expect inflation to top 3 percent by March. They were also surprisingly optimistic about the global economy and indicated that they expect high capacity utilization and worker shortages to persist. In other words, they remain hawkish. Meanwhile the Canadian dollar also hit a fresh record high against the US dollar thanks to a stronger IVEY PMI report. Despite a significantly appreciated currency, manufacturing activity has not slowed materially. Yet this does not mean that the Bank of Canada is not worried. Senior Deputy Governor Jenkins said today that should the Canadian dollar remain at current levels, it would pose significant downside risks to growth. When asked if intervention could be possible, instead of denying it, he said that in order for intervention to be effective, it would have to be followed up by other policy actions. For the time being, we do not think intervention is likely, but if the US economy slows significantly and the loonie remains below parity, the Bank of Canada may seriously consider that possibility. As for the New Zealand, it has benefitted from the overall rise in commodity prices. Third quarter unemployment is due for release tonight and the numbers are expected to continue to reflect a tight labor market.

ECB??™s Only Option is to Be Hawkish
The Euro is slowly inching towards the psychologically important 1.50 level. Today the single currency made a new record high on the back of broad dollar weakness and stronger inflation and service sector data. We are less than 48 hours away from the ECB??™s interest rate decision and even though no one expects rates to be increased, everyone does expect ECB President Trichet to become increasingly hawkish. Today??™s economic data provides further evidence of why hawkish policy is his only option. With producer and consumer prices both continuing to climb, inflation is a persistent problem. Oil prices were up another $2.70 today which will only exacerbate inflation in the months to come and the ECB is fully aware of that. Having been so proactive with injecting liquidity in the midst of the credit crunch in August, the ECB may choose to be proactive again with combating inflation. They need a strong Euro to offset the rising the cost of oil which is why we haven??™t heard one word of complaint from Trichet even though the Euro has risen above 1.45. Also, the latest service sector PMI data indicates that the impact of the strong Euro on the overall economy is still limited. However not all news was good news; Eurozone retail sales were softer than expected. As long as spending is increasing and not decreasing, we are not worried.

US Dollar Continues to Weaken as Banking Sector Turmoil Raises Rate Cut Expectations
The US dollar is weaker across the board despite the lack of any US economic data. The rally in stocks and move in the US dollar suggests that a growing number of traders believe the Federal Reserve will bail out the banking sector with another interest rate cut. Over the past few weeks, banks have reported far larger than anticipated write downs, CEOs have been ousted and seasoned fund managers like Bill Gross warned that things are only expected to get worse. However as much as we know that a part of the Fed??™s responsibility is to ensure stability in the banking sector, the rise in bond yields across the curve suggests that bond traders who are often the most accurate predictors of Fed activity do believe that a rate cut next month is a done deal. The only hope would be for Fed Chairman Ben Bernanke to clear the air on Thursday when he testifies before the Joint Economic Committee. Being a central banker in the current market environment isn??™t easy. Global growth could turn on a dime while inflationary pressures increase on a near daily basis.

British Pound Advances Towards 2.10
In yesterday??™s Daily Fundamentals, we said the biggest driver of British pound strength and weakness is US fundamentals and not UK fundamentals and today is a perfect example of that dynamic unfolding once again. Both the GDP estimate and the BRC retail sales monitor were weaker than the prior month but neither was a surprise given the overall trend of weaker economic data. When compared to the upside surprises in Eurozone data, it is not hard to understand why EURGBP has been rallying three days in a row. Bank of England Governor King was also on the wires warning that it could be several months before banks return to normal. In the meantime, there is no UK economic data due for release tomorrow but the BoE will begin their 2 day monetary policy meeting.

Dow Up 117 Points, Taking Carry Trades Higher in the Process
With the Dow up 117 points today, it would be surprising if carry trades or the Japanese Yen crosses did not rally. The biggest strength was in NZD/JPY, AUD/JPY and CAD/JPY all of which benefitted from the sharp rise in commodity prices. Leading indicators were flat which was right in line with expectations. This represents a deterioration from the prior month??™s data. The Bank of Japan has zero room to alter interest rates even though Fukui hinted of a rate hike yesterday. As a country that imports nearly all of its oil, Japanese consumer spending stands to suffer greatly from the rise in oil prices which means that the rebound in the Japanese economy last quarter could be short lived.