Tides Shift for the Federal Reserve and ECB

DailyFX Fundamentals 04-28-08

By Kathy Lien, Chief Strategist of DailyFX.com

Three reasons why the EUR/USD may continue to fall

After hitting a record high above 1.60, the EUR/USD has fallen over 400 pips. The failure to extend far beyond 1.60 should not be incredibly surprising if you have been following the Daily Fundamentals.

Last Tuesday, when the Euro broke the psychological level, we pointed out that the lack of major option barriers above 1.60 suggested 'the power of the move above 1.60 will not be as strong as the move above 1.50. In fact, 1.60 could even be a near term top.'

On 22 April, our Technical Analyst Jamie Saettele said that EUR/JPY was ready for a top. Since then EUR/JPY has fallen over 150 pips and now looks prime for further losses. Looking forward, there are three primary reasons why I think this could be a temporary bottom for the US dollar and the beginning of further losses for the Euro.

The first is the upcoming Federal Reserve interest rate decision. Not only is the market growing increasingly confident that the Federal Reserve will only cut interest rates by 25bp on Wednesday, but they also believe that the Fed will pause.

Although no comments have been made over the past few weeks by Fed officials to specifically suggest this, the continual rise in oil, steel and rice prices has everyone guessing that inflationary pressures may force Reserve Chairman Ben Bernanke to start taking tips from former Fed Chairman Volcker, who fought double digit inflation with interest rates as high as 20%.

Although I think that 25bp is all that we will get from the Federal Reserve, their decision may not be an easy one as non-farm payrolls are expected to fall for the fourth month in a row.

The second reason is the recent flip in the FXCM Speculative Sentiment Index. Speculators have been net short the EUR/USD since 2006 and during that time, the currency pair rallied from 1.25 to 1.60. For the first time since 2006, the index has flipped into positive territory, which gives us a strong sell signal.

The third reason is the technical outlook for the EUR/USD. According to our Daily Technicals report, the EUR/USD is in the process of undergoing its fourth wave correction and support does not begin until 1.4667.

Tides shift for the Federal Reserve and ECB

The EUR/USD has come under selling pressure as the tides shift for both the Federal Reserve and the European Central Bank.

With inflationary pressures rising, the Federal Reserve is facing growing pressure to stop cutting interest rates. Even though US economic data has been weak and is expected to continue to deteriorate with tomorrow's consumer confidence and house price reports, talk of the possibility of $200 for a barrel of oil by OPEC and $10 a gallon of gasoline has everyone fearing that inflationary pressures will only escalate in the coming months.

Interestingly enough, inflationary pressures have been limited on the consumer level. According to the preliminary German CPI numbers, consumer prices actually dropped in the month of April.

This suggest that producers who saw their prices rise to a 15 month high last month have not been able to pass on higher costs to consumers.

Weaker economic data and slower growth could force the ECB to lean towards easier monetary policy. Retail PMI is due for release tomorrow; if spending also slows then a rate cut could be in the Euro's future.

Pound Sterling could fall victim to housing market data

The Sterling has strengthened against both the US dollar and the Euro on news that HBOS could raise up to GBP4bn in a rights issue.

Although the mortgage lender faces up to GBP3bn worth of write downs, the new capital infusion is news that is very much welcomed by Sterling traders.

Unfortunately, trouble in the UK housing market is not behind us. Tomorrow we have a number of housing market reports due for release including mortgage approvals, net lending and consumer credit. The CBI Distributive Trades report is also expected and there is only a slim chance that spending would have increased given the problems in the financial sector, the slowing housing market and the prospect of a further deterioration in the labour market.

Unconvincing rally in Canadian, Australian and New Zealand Dollars

The Canadian, Australian and New Zealand dollars strengthened against the greenback but their rallies are unconvincing.

All of the three currencies failed to rally above its high on Friday and could now be vulnerable to more losses given the afternoon sell-off in US stocks.

The main reason why commodity currencies rallied on Monday is the move in oil and gold, which have continued to edge higher. The New Zealand trade balance is due for release this evening along with money supply. The market expects the trade surplus to increase given the rise in commodity prices but the risk is to the downside given the drop in New Zealand PMI. A

ustralia on the other hand will be reporting business confidence and new home sales, both of which could reflect slowing growth. There are no releases expected from Canada.

US stocks give back gains, dragging carry trades lower

The rally in USD/JPY is getting tired. Having moved from a low of 100.31 two weeks ago to a high 104.82 on Friday, the currency pair is vulnerable to a correction.

US stocks moved into negative territory near the end of the trading session and economic data tomorrow is expected to be dollar negative. With the Euro having its own share of problems, weak US numbers may be better reflected in USD/JPY instead of the EUR/USD, especially since we had some good news from Japan.

Large retail sales increased 0.2% in March while sales in general rose 0.5%. There is a good article the financial papers talking about how the pickup in inflation that Japan has been craving is coming from the worst place possible. Instead of prices being driven higher by growing demand, they are rising because of speculative interest.