ECB Expected to Leave Interest Rates Unchanged

DailyFX Fundamentals 02-06-08

By Kathy Lien, Chief Strategist of www.dailyfx.com

When Will the Dollar Rally End?

Stocks are melting down, US economic data is weak and yet the dollar continues to rally. Yesterday we talked about how it has been a long time since we have seen a broad based dollar rally and today the mixed performance of the US dollar is much closer to the price action that we have grown accustomed to. The dollar extended its strength against the Euro, British pound and Australian dollars, but lost ground to the Japanese Yen, New Zealand and Canadian dollars. With the only reason for the dollar's rally being risk aversion, many traders are wondering when the dollar rally will end. Our answer is, possibly tomorrow when the Bank of England and the European Central Bank announces their interest rate decisions. With one expected to cut interest rates and the other leaving it unchanged, the Federal Reserve rampage to lower interest rates could do the dollar in. Interestingly enough, today's comments from Fed officials touched on a tone of hawkishness. Both Fed Presidents Lacker and Plosser said that even though the US economy could worsen and consumer spending should weaken further in 2008, they are worried about inflation. Oil prices continued to slip but platinum and gold prices are rallying. Productivity was stronger than expected in the fourth quarter, but labor costs growth was muted. This indicates that workers are growing more productive simply because companies are cutting hours. Pending home sales, consumer credit and jobless claims are due for release tomorrow. The housing market remains a big cause for concern and home owners are resorting to selling their property in the more creative ways such as participating in online auctions. Jobless claims, which we usually pay less attention to will be a number to watch as well because last week, claims rose by the largest amount since Hurricane Katrina. If they do not retrace, then we could be looking forward to another negative non-farm payrolls report for the month of February.

ECB Expected to Leave Interest Rates Unchanged

The European Central Bank is widely expected to leave interest rates unchanged tomorrow at 4.00 percent. The actual rate announcement should cause minimal volatility in the Euro unless the ECB actually alters interest rates. What will drive the fluctuations in the currency will once again be the comments from European Central Bank President Trichet. Will he admit that the next move by the ECB will be a rate cut and not a rate hike? Probably not. Even though recent economic data including Eurozone retail sales and service sector PMI indicates that the region has been hit by slower growth, inflation remains a big problem. Governing Council member Liebscher reminded the markets on Friday that their entire efforts must be directed at reducing the increases in prices. Therefore we expect Trichet's comments to remain unchanged but he will be pressed to address how resilient the Eurozone economy really is to the slowdown in the US and if he even wavers in his belief that the region will continue to grow, watch out for further losses in the Euro. Any slide however should be limited to 1.45 because Eurozone interest rates are still 100bp higher than US rates and this spread is expected to widen further in the Euro's favor. Meanwhile Switzerland will also be releasing their unemployment figures for the month of January; they are expected to remain unchanged.

Bank of England Expected to Cut Interest Rates

The Bank of England is expected cut interest rates by 25bp to 5.25 percent. This would be the second rate cut for the central bank since they began lowering interest rates in December. Getting the BoE to cut rates has been like pulling teeth. Each rate cut that they have doled out has been a reluctant one. Tomorrow will be no different because the UK has to balance slowing growth with rising inflation. According to the shadow committee that tries to vote like the BoE would, only 5 of the 9 members will favor a rate cut. This means that the statement may not be as dovish as everyone expects and if that is the case, the British pound may actually rally. UK economic data has also been mixed with a drop shop prices and a decline in consumer confidence offset by yesterday's rise in service sector PMI. Before the BoE rate decision, we do have UK industrial production, which is suppose to be weak following the drop in manufacturing PMI.

Strong Canadian and New Zealand data Lifts Commodity Currencies

The Canadian and New Zealand dollars rallied strongly today on the back of better than expected economic data. Canada reported a sharp rebound in IVEY PMI and building permits. Last month, the manufacturing activity index fell to a six year low, but activity snapped back quickly in the month of January. New Zealand also reported stronger employment numbers with the unemployment rate dipping to a record low. Collectively, these two pieces of data drove the Canadian and New Zealand dollars higher. Unfortunately the Australian dollar was a laggard as carry trade selling prevented the Australian dollar from following in the footsteps of the Loonie and Kiwi.

Carry Trades Extend Losses as Stocks Reverse

The price action in carry trades or Japanese Yen crosses were extremely interesting today. Over the past few weeks, we have talked repeatedly about how the correlation between US equities and carry trades are breaking down. This morning, when the Dow was up over 100 points, carry trades refused to budge. However, when stocks started to reverse to end the day down 65 points, carry trades sold off aggressively. This indicates that risk aversion is very high in the markets right now and traders are waiting for any reason to sell carry.