Euro: More reasons to be hawkish

DailyFX Fundamentals 07-01-08

By Kathy Lien, Chief Strategist of DailyFX.com

Big reversals lift the US Dollar

The US dollar has been driven higher by big reversals in the stock market and in the manufacturing sector.

The Dow Jones Industrial Average was down as much as 160 points intraday before it reversed sharply to end the day in positive territory.

Part of this strength was due to stronger than expected sales by General Motors.

The big fear in the markets today was that Toyota would overtake GM in sales to the US, but a month end sale and zero percent financing helped the automobile giant hold onto its title.

On a day when the manufacturing ISM report blew past the market's expectations, this was not only positive for stocks, but also for the US dollar.

Regional indexes all pointed to a very weak nationwide manufacturing report, but for the first time in five months, activity the manufacturing sector increased thanks to a rise in inventories and prices paid.

The inflation component of the report actually hit a 34 year high due to higher commodity prices.

Although we remain skeptical about how well the US economy is doing, today's economic data certainly increases the likelihood of a third quarter rate hike by the Federal Reserve and that is what matters most to currency traders.

Oil prices continue to remain stubbornly high with $150 a barrel within arm's reach. Gas prices could hit $5 a gallon by the end of the summer, which would make the Federal Reserve's job even more difficult.

This is why we only expect a limited decline in the US dollar against the Japanese Yen because for USD/JPY, the direction of interest rates is clearly in the dollar's favour.

For other currency pairs such as the EUR/USD, the outlook for the 'interest rate spread' is not as clear, but that may change with the ECB meeting and US non-farm payrolls report on Thursday.

Tomorrow we are looking forward to the leading indicators for non-farm payrolls such as the Challenger layoffs report and the ADP Employment report.

Euro: More reasons to be hawkish

The Euro remains firm ahead of the ECB meeting on Thursday.

Yesterday, the June consumer price index estimate came in at 4% double the central bank's 2% inflation target.

Today, Germany reported strong consumer spending and the lowest unemployment rate in 14 years.

Manufacturing sector PMI for the Eurozone was also revised higher in the month of June due to stronger activity in France and Germany.

The combination of higher inflationary pressures and better than expected economic data could force the ECB to backtrack on their warnings and actually prepare the market up for more than one rate hike in the third quarter.

Up until now the ECB has openly hinted that a rate hike in July will one-off, but given the recent reports, two rate hikes from the ECB this year is more than realistic.

Eurozone producer prices are due for release tomorrow and given the rise in wholesale sales and import prices, we expect the PPI number to be hot.

A 50bp rate hike by the ECB on Thursday may not be out of the question. Meanwhile Swiss PMI numbers hit a three year low while the prices paid or inflation component of the report jumped to a 1.5 year high.

Pound Sterling fails to hold 2.0

For the first time in two months, the British pound hit 2.0 against the US dollar.

Unfortunately the currency pair failed to hold above this level as weaker economic pushed the currency lower.

Manufacturing sector PMI came out much weaker than expected while Nationwide House Prices fell by the fastest pace in 16 years.

Governor Mervyn King predicts further downside risks in the housing markets which may be part of the reason why he has been reluctant to raise interest rates.

Looking ahead, PMI Construction is largely expected to decline, as the sagging housing market coupled with tight lending conditions continue to be hurdles for construction companies. Other than service sector PMI on Thursday, there is no major UK data on the calendar this week.

Australian Dollar hit by dovish RBA comments and weak PMI report

To the surprise of Australian dollar traders, the Reserve Bank of Australia left interest rates unchanged at 7.25% and signalled that despite inflationary pressures, they will probably not raise interest rates again this year as demand growth is expected to moderate.

This stance is validated by the much weaker than expected manufacturing PMI report - which dropped to the lowest level since November 2005.

Australian retail sales and building approvals are due for release this evening. The increase in the sales component of service sector PMI suggests that consumer spending should rise, but RBA Governor Glenn Stevens was particularly concerned about the softness of consumer spending, which makes us skeptical of our typically reliable leading indicator for Australian retail sales.

Japanese business confidence deteriorates but not as bad as feared

Today was a particularly volatile day for Japanese Yen crosses, as the Dow recovered all of its earlier losses.

The Quarterly Tankan report was better than expected, but Japanese business confidence still fell to a four year low as the outlook for earnings remain uncertain.

This is the third month in a row that confidence has deteriorated. The global economic picture has only worsened in the past three months with oil prices taking a larger bite out of corporate profits.

Unlike the other central banks around the world, the currency market is relatively certain that the Bank of Japan will be sitting on their hands for the remainder of the year.

This limits good news from helping the Japanese Yen and bad news from hurting it. Labour Cash earnings and Vehicle Sales on the other hand did not manage to beat expectations, as consumer spending slows down to a crawl, due to rising prices.