Euro Breaks Out on Speculation that the ECB Could Raise Rates (page 1 of 2)

DailyFX Fundamentals 05-20-08

By Kathy Lien, Chief Strategist of DailyFX.com

Are higher oil prices hurting or helping the US Dollar?

Dollar weakness dominated the markets today with the greenback selling off against every major currency except for the Canadian dollar.

Liquidation is the theme as the Dow Jones Industrial Average plunged approximately 200 points. Fear that rising oil prices will continue to push inflation higher was validated by the hawkish comments from Federal Reserve Vice Chairman Kohn.

He said that 'monetary policy appears to be appropriately calibrated for now to promote both rising employment and moderating inflation over the medium term.'

Meanwhile headline producer prices fell short of expectations while core prices rose more than expected in the month of April.

This reversal of patterns is fascinating because the primary driver of higher inflation has been food and energy prices. Although it isn't a surprise to see core prices rise, the slower growth in headline prices should be nothing more than a correction within an overall uptrend.

The US government has already increased their predictions for food price growth by half of a percentage point and the latest uptick in oil prices will only exacerbate inflationary pressures.

This is undoubtedly a big problem for central banks, but the bigger question for currency traders is whether the uptrend in oil prices will hurt or help the US dollar.

Taking a look at the oil shocks of the 1970s (1973 and 1979), we see that the trade weighted exchange index for the US dollar rallied for the first few months and then sold off.

At that time, the Federal Reserve was aggressively raising interest rates to combat skyrocketing inflation which was initially positive for the dollar, but when the market realized that the combination of high inflation and high interest rates could cripple the economy, they began to sell the US dollar aggressively.

Oil price shocks have caused or contributed to each of the recessions endured by the US economy over the past 30 years because each 10% in oil shaves 0.3% to 0.4% off of GDP. That is why the Federal Reserve's job is exceptionally difficult.

The uptrend in crude currently poses a bigger risk to inflation than growth. Economic data has been stabilizing, which buys the central bank time by allowing them to keep rates unchanged in June.

However the uptrend in oil will start undermining the Fed's efforts when the strain is finally evident in the retail sales reports. If we start seeing a big contraction in consumer spending, the Fed will have to ease again, at which time the rise in oil prices will be big trouble for the US economy and the US dollar.

Euro breaks out on speculation that the ECB could raise rates

After consolidating for the past week, the Euro rallied more than 250 pips against the US dollar.

Producer prices grew by 1.1% last month or 5.2% on an annualized basis, which was the fastest pace of growth in almost 2 years.

Strong inflationary pressure has prompted Wolfgang Franz the President of the ZEW to forecast a rate hike by the ECB in the near future. Even though investor confidence towards Germany hit a 15 year low, traders took the Euro higher on the hawkish inflation data and Franz's comments.

ECB member Marko Kranjec was also relatively optimistic about the outlook for the Eurozone economy when he said that recent economic data shows that the fundamentals of the Eurozone economy are strong.