The EUR/USD Range Trade (page 1 of 2)

DailyFX Fundamentals 06-09-08

By Kathy Lien, Chief Strategist of DailyFX.com

US Treasury and Federal Reserve Join Forces to Talk Up US Dollar

With inflation skyrocketing and gas prices hitting an average of $4 a gallon, the US government wants the dollar to rise. Federal Reserve Chairman Ben Bernanke first hinted that FX intervention is possible last week and today US Treasury Secretary Paulson confirmed that the US government is not ruling out any policy tool including intervention. The last time the Federal Reserve intervened in the currency markets was shortly after the launch of the Euro. At that time, the currency fell to a low of 84 cents, triggering panic for the European Central Bank. In response to the sharp sell-off in the EUR/USD, the ECB convinced the Fed to jointly intervene in the currency markets to buy euros and sell US dollars. Since there has been no intervention for more than 7 years, stepping into the markets would represent a dramatic policy shift for the US government. The reason why talk of intervention has resurfaced is because the US government may be running of options. Typically, raising interest rates is the most effective way to curb inflation, but with the labor market deteriorating and high energy prices threatening consumer spending, the Federal Reserve is reluctant to raise interest rates. This leaves strengthening the dollar as one of the easiest and possibly the quickest way to bring down inflation. Although we do not expect the US government to do more than jawbone the dollar, their bias for where the dollar should head is now clear. In the past, the Federal Reserve wanted the dollar to fall to boost exports and growth, but they have now flipped their stance and instead they want the dollar to rise. Meanwhile the surprising jump in pending home sales added fuel to the recovery in the greenback as the 6.3 percent rise was the strongest one-month increase in 6 years. The trade balance is due for release tomorrow, we expect the deficit to shrink as exports rebound.

The EUR/USD Range Trade

Last Thursday, European Central Bank President Trichet warned the markets that a 25bp rate hike could come as early as July. This led to a sharp rally in the EUR/USD, but despite this strength and the clearly hawkish comments, the Euro may have a difficult time making a run for 1.60. For the EUR/USD, US fundamentals are just as important as Eurozone fundamentals, which is why last week's developments in the US and the Eurozone could prevent the EUR/USD from breaking out of its recent range. After cutting interest rates by 325bp, the Federal Reserve is bringing monetary easing to a close. We have not seen the last of the US government's attempt to engineer a dollar rally, which could draw attention away from the expected rate hike by the ECB. Furthermore, according to the recent price action in the bond markets, there could be significantly slower growth in the Eurozone economy in the months ahead. For the first time since August 2000, the European yield curve, which is a strong leading indicator for the business cycle has inverted. The US yield curve inverted in 2006 and lasted into 2007, accurately forecasting the subprime credit crisis.

Soaring Inflation Drives the British Pound Higher

The British pound extended its gains as producer prices grew by the fastest pace in over 20 years. Output and input prices increased more than expected on both a core and headline level confirming that inflation is moving beyond food and energy.