Is the Euro Becoming Immune to Hawkish Comments?

DailyFX Fundamentals 05-19-08

By Kathy Lien, Chief Strategist of DailyFX.com

Will This Be A Dollar Positive Week?

The US dollar has started the week strong thanks to the better than expected leading indicators report.

For the second month in a row, leading indicators increased, suggesting that the US economy may not be in a recession.

Although the numbers are definitely encouraging, we believe that recession or no recession is just a matter of semantics. The bigger question is whether or not the current downturn will be shallow.

With the Fed signalling an intention to pause when they meet to discuss monetary policy in June, the market is looking for any data that would confirm that stability is the new course for the US economy. The LEI numbers are certainly encouraging even though we are slightly suspicious of whether the improvements are more than just a rebound.

Building permits, stock prices and the interest rate spread were the biggest gainers, but the two former components saw a big decline the prior month.

The US economy is still at risk for slower growth, but that should not draw away from the fact that the market perceives the news as dollar bullish. This strength should continue into tomorrow's producer price report. Not only have food and oil prices increased last month, but the import price report also surprised to the upside.

The dollar should remain firm in the beginning week as there is nothing to threaten its rise until Friday when we are expecting the existing home sales report.

Traders still need to be cautious of what they buy because even though we believe that the dollar should strengthen against the Euro this week, it could continue to sell off against the Canadian dollar.

Is the Euro becoming immune to hawkish comments?

The Euro weakened against the US dollar today despite hawkish comments from ECB President Trichet.

The central bank head reminded the markets about the danger of letting second-round effects get out of hand and compared the recent rise in food and energy prices with the 1970s oil shock.

He said that cutting interest rates now could lead to more serious problems in the future. Yet the Euro has barely budged on the comments, suggesting that traders are starting to become immune to the hawkish rhetoric.

Part of the reason for this lack of response is the recent turn in Eurozone economic data. Everyone is beginning to wonder how much longer the ECB will be able to remain hawkish given the gradual deterioration in the Eurozone economy.

This week will be a big test with the ZEW survey, the IFO report and the PMI numbers due for release. The market is actually expecting analyst sentiment to improve and business confidence to deteriorate.

German factory orders and industrial production have all declined, confirming that activity is slowing; it would be a surprise if analysts' sentiment actually managed to improve. In addition to the ZEW survey, German producer prices are due for release tomorrow morning. The rise in wholesale prices suggest that producer prices will surprise to the upside, lending credibility to the ECB's inflation battle.

Pound Sterling resumes weakness despite stronger housing market data

Good news rarely comes out of the UK housing market these days and therefore we are surprised to see the lack of a response to the stronger housing market numbers.

This may be partially due to the fact that even though online property search firm Rightmove reported a 1.2% rise in house prices during the month of May, they also criticised UK homeowners for raising prices in the current market environment.

Even Bank of England Governor King has warned that prices are set to fall further, but sellers have refused to adjust their prices to more realistic levels. If this trend continues, the housing market inventory will grow and eventually prices will have to come down.

Either way, a rate cut by the BoE is not on the cards right now according to the interest rate market.

The spread between 2 and 10 year gilts are on the brink of inverting for the first time in six months, which means that no one expects the Bank of England to cut interest rates anytime soon.

We expect this same concern about inflationary pressures to be reflected in Wednesday's release of the minutes from the latest Bank of England meeting.

Australian Dollar hits 24 year high, Canadian Dollar continues to rise

The Australian dollar hit a fresh 24 year high at the opening of the Asian trading session, but those gains were quickly erased following weaker Australian and New Zealand economic data.

Imports decreased 3% in the month of April, reflecting the softer demand for external goods by Australians.

The New Zealand dollar on the other hand is suffering from yet another piece of disappointing economic data. The service sector PMI index slipped from 50.8 to 48.9 in the month of April, indicating that activity is now contracting.

Last week, we saw a decline in retail sales and based upon the latest the drop in the employment component of the PMI report, the labour market and domestic demand should remain weak. The Canadian dollar on the other hand was the only currency that managed to strengthen against the greenback today. There was no economic data released, but we do expect stronger Canadian CPI on Wednesday.

Bank of Japan expected to keep interest rates unchanged

With no major economic numbers other than the US leading indicators report released this morning, carry trades have moved in lockstep with the Dow. US stocks were up more than 150 points intraday, triggering a sharp rally in carry trades.

However other than USD/JPY and CAD/JPY, none of the Japanese Yen crosses managed to hold onto their earlier gains. The Bank of Japan is expected to leave interest rates unchanged tonight, which should be a nonevent for the Japanese Yen.