US Dollar Strengthens as Inflation Data Surprises to the Upside (page 1 of 2)

DailyFX Fundamentals 02-21-07

By Kathy Lien, Chief Strategist of DailyFX.com

US Dollar- US consumer prices were slightly better than expected today which helped to contribute to the overall strength of the US dollar. Having rallied going into the release of the CPI report, the true impact on the dollar was limited. Central banks were the focus of the day with interest rate decisions, comments and minutes from prior meetings occupying the calendar. The Bank of Japan's decision to raise interest rates gave little support to the Yen in light of the dovish comments from BoJ Governor Fukui following the decision. The British pound remained under pressure as the minutes from the most recent BoE meeting suggests that the central bank will need more time to assess data before tightening rates again. Comments from the central bank governors of Australia and Switzerland indicate that both policy makers are looking to lift interest rates over the next year. In the US, the minutes from the January FOMC meeting delivered no surprises. The Federal Reserve was relatively upbeat about growth and agreed that inflation risks still remain. Even though another rate hike was "not warranted" at the time, they decided against dropping the tightening bias. The tone of the statement contained the same degree of hawkishness as the comments made by Fed Chairman Bernanke last week, which should keep the prospects of a rate hike later this year in play. A deeper look at today's US data indicates that the rise in core prices was driven by higher medical costs and tobacco prices. Leading indicators fell short of expectations for the month of January, but the sharp upward revision in December offset any negative implications. Looking ahead, the dollar could retain its strength against the Japanese Yen and British pound because of the divergence in monetary policy outlooks between the US, Japan and Great Britain. At the same time, it could be vulnerable to further losses against the Euro and commodity currencies, where the monetary policies of those countries are slightly more aggressive than that of the US.

Euro - The Euro is slightly higher against the US dollar today thanks to a stronger current account report, hawkish monetary policy and carry trade demand for the Euro against the Japanese Yen, which hit a fresh record high today. Not only did the Eurozone current account surplus increase instead of decrease in the month of December as the market expected, but the November balance was also revised from
-2.0B to 0.9B. Consumer prices in France and Italy were slightly weaker than expected but not enough to shift the ECB's monetary policy outlook. The second release of German GDP is scheduled for tomorrow but no changes are expected. The bid tone in the EUR/USD today is primarily related to EUR/JPY demand. Carry trades are back in play after the BoJ signaled that further rate hikes will be slow and gradual. The Euro has become one of the preferred carry trade currencies to earn interest on because of the central bank's plans to raise interest rates next month. The market has paid zero attention to the resignation of Italian Prime Minister Prodi which could catch up to the Euro in the coming days. Meanwhile Switzerland's central bank President Roth said that interest rates were too low to control inflation. However the impact on the Swiss Franc was limited because he expects the economy to weaken in the second half of the year.

British Pound - The British pound is weaker against the US dollar and the Euro after the release of the minutes from the most recent monetary policy meeting.