Growth Takes Backseat to Stronger Inflation Pressures (page 1 of 2)

DailyFX Fundamentals 06-27-07

By Kathy Lien, Chief Strategist of DailyFX.com

Dollar Strengthens Ahead of FOMC as Weaker Growth Takes Backseat to Stronger Inflation Pressures

The US dollar has strengthened ahead of the FOMC meeting despite the larger than expected drop in durable goods orders in the month of May.

The US economy is clearly facing problems as the weakness in durable goods follow disappointments in both existing and new home sales. However, the problems in the economy will take a back seat to inflation risks at tomorrow's FOMC announcement.

Consumer and producer prices were both up in the month of May and based upon the recent increase in corn and dairy prices as well as the mild change in the US stock market, the Federal Reserve is not likely to loosen their leash on inflation. Oil prices also jumped over 1 percent today after reports of lower US fuel supplies. Crude prices are now $1 shy of its nine month high.

At this point, the Federal Reserve does not have much choice other than to keep the tone of the statement unchanged in order to tame the stock market bubble. The key phrases to watch are the ones in reference to the housing market and inflation.

A bigger focus on housing market problems will most likely lead to more pronounced dollar weakness against the Euro than the Japanese Yen because the market anticipates another interest rate hike from the European Central Bank this year while shorting USD/JPY would require paying a hefty interest.

By the same token, if the tone of the statement remains unchanged, expect USD/JPY to benefit more than the Euro. For a more detailed
outlook on what the Federal Reserve meeting could mean for the US dollar, see our special FOMC Report.

Japanese Yen Skyrockets on Stronger Economic Data and Not Just Risk Aversion

For the third consecutive trading day, the foreign exchange market has been obsessed with the strength of the Japanese Yen. Rising risk aversion continued to be blamed for the move, but with the Dow up over 90 points today, it is difficult to believe that investors are really all that risk averse.

Instead, the rally is more likely driven by the turnaround in the Japanese economy. Having struggled to grow for the past few months, we are finally beginning to see Japan reap the benefits of Yen weakness. Last night, the country reported the first positive reading in annualized retail sales in eight months. This follows yesterday's announcement that the Corporate Service Price Index (CSPI) hit a nine year high in May.

The combination of rising consumer spending and growing inflationary pressures is just what the Bank of Japan needs to see before raising interest rates again. Industrial production which is due for release this evening is also expected to swing into positive territory in May.

At this point, there is also a decent chance that we will see stronger consumer prices on Thursday. If everything prints positive, then a 25bp rate hike on July 12 or August 23rd becomes a real possibility. With the Dow rebounding and the FOMC announcement tomorrow afternoon, further carry trade unwinding may be limited.

Euro Stuck in a Range; Swiss Franc Weakens After KoF

The Euro continues to be stuck in a tight trading range that is typically more characteristic of a currency pair like EUR/GBP or EUR/CHF. Economic data has been light with French business confidence being the only piece of noteworthy economic data released from the Eurozone today.