British Pound Slips Ahead of Quarterly Inflation Report (page 1 of 2)

DailyFX Fundamentals 08-07-07

By Kathy Lien, Chief Strategist of DailyFX.com

Dollar reverses after FOMC signaling that traders do not believe Fed will stay hawkish for long

It has been some time since we've seen this degree of volatility in the financial markets following an interest rate decision.

As expected, the Fed left interest rates unchanged at 5.25 per cent, but both the US dollar and the US stock market tanked on the back of the monetary policy statement. The statement was as hawkish as it could be given current market conditions.

Although the Fed felt that the downside risks to growth have increased, they still believe a strong labour market and growing incomes will keep economic growth stable. They also acknowledged that volatility in the markets have increased and credit conditions have become tighter, but at this point, the problems are not severe enough for them to stop worrying about inflation and start focusing on growth.

The rollercoaster price action in the financial markets suggests that traders are still trying to figure out whether or not to believe the Federal Reserve's attempts to calm the market. The central bank clearly needs more evidence than the few bankruptcies and blowups that we have seen thus far to shift their tone.

Unfortunately there is never just one cockroach in the closet. More adjustable rate mortgages will be repriced over the next six months, which means the risk of defaults will continue to rise. Even if the Fed is right, the age of easy money is over and everyone will be far more careful about the degree of risk that they are willing to take.

Therefore don't expect a rebound back to all time highs in the US stock market. Instead, it is more likely that we see the US dollar slip back towards its record lows against the euro.

Today's Fed meeting was supposed to set the tone for trading for the remainder of the week. At this point however, it seems that the market is more doubtful of the FOMC statement than anything else. This makes the release of the minutes and any further Fed speak even more important.

Reserve Bank of Australia expected to raise interest rates

Now that the FOMC meeting is behind us, the next interest rate decision is in Australia. The Reserve Bank is widely expected to lift interest rates from 6.25 per cent to 6.50 per cent. Consumer price growth in the second quarter was 2.1 per cent, which is within their two to three per cent inflation target.

However the prospect of higher inflation in the months to come will force the central bank to be proactive with raising interest rates. Retail sales have been hot and businesses are becoming more optimistic. The market has already priced in an 80 per cent chance for a rate hike, so like the Fed meeting, the key focus will be on the RBA comments afterwards.

The market is actually not expecting the RBA to raise interest rates again this year. The Australian dollar has weakened going into the RBA rate decision due to softer than expected construction sector PMI data last night. The index dropped into contracted, signaling that the housing market may have hit its peak.

The Canadian and New Zealand dollars are also weaker despite a continued rise in New Zealand's ANZ commodity price index.

British pound slips ahead of quarterly inflation report

The Bank of England (BoE) will be delivering its Quarterly Inflation Report tomorrow.