US Dollar's Flight to Safety Status Cracks on the Weight on Weaker Data (page 1 of 2)

DailyFX Fundamentals 09-05-07

By Kathy Lien, Chief Strategist of DailyFX.com

ECB Rate Decision: Expect a Break in the Euro

The disturbing weakness of today's US economic data has distracted everyone from the second most important event risk this week, which is tomorrow's European Central Bank (ECB) interest rate decision.

Typically the ECB likes to let the market know at least a month in advance what they plan on doing with interest rates. This time however, Trichet and company will have traders guessing up to the last second.

There are three potential outcomes of this much anticipated rate decision. The first and the most unlikely is if the ECB raises rates to 4.25 per cent. This surprisingly hawkish move would be extremely positive for the euro, taking the currency pair back above 1.3700.

The second scenario is for the ECB to leave rates at four per cent, drop the words strong vigilance and add some other dovish comments that would allude to interest rates remaining unchanged for the remainder of the year. This would be extremely bearish for the euro, taking it back below 1.3550.

The third scenario would be for the ECB to leave interest rates unchanged and make convoluted or slightly hawkish comments (which may or may not include the words strong vigilance and in essence leave the door open for further rate hikes). In this case, the reaction in the euro should be limited.

Given the recent move in European bond yields, the ECB really has no choice but to leave interest rates unchanged. Economic data has been mixed while inflation pressures have been modest.

The only area of concern is the financial markets and how much damage US sub-prime losses may have had on the German banking sector. Expect tomorrow's rate decision to take the euro out of its 1.3550 to 1.3680 trading range.

US Dollar Loses Flight to Safety Status on the Weight on Weaker Data

The Dow plunged 150 points today, taking carry trades down with it. Economic data was very weak, foreshadowing even more difficult times ahead for the US economy.

Over the past few weeks, we have seen the dollar rally on weak US economic data because both domestic and international traders flocked to the safety of US treasuries.

However the lack of a rally in the currency today suggests that the US economic outlook could be so poor that even international traders are looking to parking their money elsewhere while domestic traders are just moving back into cash.

The US three month LIBOR rate rose for a 10th day in a row, reaching new six year highs. Not only does this mean that lenders are unwilling to offer cash for any time longer than a few days, but it also means that consumers and businesses will become more strained in the months ahead since the rate affects everything from adjustable rate mortgages to floating rate bank loans.

For this reason alone, the Fed will need to cut interest rates. But on top of that, today we saw pending home sales drop 12 per cent in July while the ADP employment survey increased by a pathetic 38,000, well below the market's 80,000 forecast.

Taken together with the 6.6 point drop in the Hudson employment index, it will be difficult for non-payrolls to break the 100k mark. Even though the stock market and carry trades extended their losses after the Beige Book report, the release was actually quite mild.

The various Fed districts reported a slowdown in the housing sector but outside of that, the impact of the turmoil in the financial markets has been limited.