Euro hits Record High of 1.3835 (page 1 of 2)

DailyFX Fundamentals 07-18-07

By Kathy Lien, Chief Strategist of DailyFX.com

Bernanke shifts tone, sending dollar to record low against the euro

To the surprise of the market, Federal Reserve Chairman Ben Bernanke shifted his tone ever so slightly in his congressional testimony on the economy and monetary policy.

Back in February, when he gave his last testimony, Bernanke said that the housing market was stabilising, but now he feels that the problems in housing could get worse before it gets better. The Fed's vocal concern about contagion indicates that "in their books" the economic environment has deteriorated enough to begin considering putting growth ahead of inflation.

For a central banker that wants to stake his reputation on fighting inflation, this is significant. Bernanke also reminded us that the Fed's primary focus is on core prices and not headline prices.

Even though oil prices are rising, he felt that unless we have another big jump, core prices could edge a bit lower. The Fed cut their growth forecasts for 2008 to between 2.5 and 2.75 per cent from 2.75 to three per cent and increased its unemployment forecasts from 4.5 per cent to 4.75 per cent.

The central tendency for core inflation was left unchanged at two to 2.25 per cent for 2007 and 1.75 to two per cent for 2008. This indicates that it expects inflation to slow over the next year.

Today's economic releases provide support to the Fed's cautionary stance. Headline consumer prices were stronger than expected, but core prices were right in line with expectations. Even though the gain in core was slightly higher than the rise in May, it is only modestly so. Starts increased but building permits hit a 10 year low, indicating that housing continues to be a problem.

Bond yields and the US dollar dropped on the back of Bernanke's comments, but further dollar weakness could be limited by the fact at this point, the Fed can do little more than raise red flags.

British pound breaks 2.05 on dollar weakness and Asian buying

The British pound first broke the psychologically important 2.05 level against the US dollar in the middle of the Asian trading session. Keying off of the stronger UK inflation data reported yesterday and the weaker US PPI numbers, Asian traders aggressively bought the GBP/USD, taking the pair up from 2.0490 to 2.0549 in a little more than an hour.

However once European traders came into the market, they began to take profits and initiate short positions. The correction was exacerbated when the less hawkish Bank of England minutes were released; the GBP/USD eventually sold off to 2.0460. Once Bernanke began to talk however, dollar selling resumed and the GBP/USD took off once again, ending the US trading session not far from the new 26 year high set overnight.

The reason why examining the price action is so important is because it tells us that today's strength in the GBP/USD is driven almost exclusively by dollar weakness and not pound strength. If anything, the Bank of England minutes signals that even if we do have another rate hike this year, it will not be until the latter part of the fourth quarter, at the earliest.

Yesterday we indicated that anything short of a 7-2 vote in favour of raising rates would be construed as dovish. The rate hike earlier this month was supported by only six out of the nine members. The dissenting views amongst the monetary policy committee members indicate that as a whole, they are not in as much of a rush to raise rates as the market may have initially thought.