Inflation, oil prices worry traders

The US economy has shown signs of suprising strength in recent months, but indications that inflation may be rearing its ugly head, particularly as oil prices have put investors on the edge.

Euro

US dollar started the week on a positive note, helped by a slide in oil prices after the meeting of group of seven and OPEC partners. The G7 statement and Saudi Arabia's decision to raise output despite opposition from other OPEC members helped the dollar move on the front foot.

Greenback's upward momentum came to a halt as analysts said the dollar could bear the brunt of concerns about longer-term high oil costs because this could further widen the US trade deficit and damage consumer spending.

US oil prices held above $41 a barrel for most of the week as markets waited to see if an expected rise in oil inventories would be enough to meet peak holiday season demand for gasoline.

Investors are questioning whether high oil prices would harm US growth prospects and deter US Federal Reserve from raising interest rates from a 46-year low of 1.0 percent.

Euro drew support from a mild recovery in German business expectations and confirmation the euro zone's biggest economy grew in the first quarter at its fastest pace since 2001. The German economy grew 0.4 percent in the first quarter, bolstered by strong demand for exports.

It was the strongest quarterly growth since the first three months of 2001. In other news from euro land, European Central Bank governing council member Axel Weber said the bank is ready to cut interest rates if a sustained period of high oil prices threatens an economic recovery.

Euro' gained strength as investors shrugged off mildly positive US housing and consumer confidence data. The US consumer confidence index rose to 93.2 for May from a revised 93.0 in April, boosted by strong job growth. US existing home sales rose to 6.64 million in April from 6.48 million in March.

Market was expecting 6.45 million. US new home sales shrank 11.8 percent from an upwardly revised record high in March. Greenback suffered another blow as US durable goods fell 2.9 percent in April, compared with an upwardly revised 5.7 percent rise in March.

Inflation in the eurozone has surged to an annual rate of 2.5 per cent this month, the highest for more than two years, on the back of sharply higher oil prices. The pick-up adds to the discomfort of the European Central Bank, which has a policy-setting meeting next week.

It is now more likely that inflation in 2004 will exceed its price stability target of below but close to 2 per cent for the fifth year running. But a rate increase would set back the eurozone's modest recovery. May's figure compares with an annual rate of 2 per cent in April and was the highest since March 2002, Eurostat, the European Union's statistics agency, said on Friday.

Economists, most of whom expect the ECB to hold rates steady on Thursday, said the oil price was the main factor behind the latest increase but inflation had also been driven higher by the government-regulated prices of tobacco and health services.

US dollar finished the week on a positive note after a week of pounding. U.S. consumer spending rose in April and a measure of business in the Chicago area increased to the highest level in almost 16 years, adding to evidence that economic growth is strengthening.

The dollar rose against the euro after an index of manufacturing in the Chicago area climbed to its highest since 1988 in May, adding to evidence that the U.S. recovery will be sustained. An index of area business by the National Association of Purchasing Management-Chicago advanced to 68 this month from 63.9 in April.

May is the 13th month of expansion, reflected by readings above 50. April consumer spending rose and incomes had the biggest gain in five months, separate reports showed

Range for the week: $1.2000 - $1.2500.

Japanese Yen

Japanese yen also moved higher on the back of weak US dollar and rising Nikkei but persistently high oil prices weighed on Tokyo stocks and capped it move higher.

Market showed little reaction to a rise in Japan's trade surplus, which was up 30.3 percent in April from a year earlier at 1.0791 trillion yen, roughly in line with market consensus forecast of 1 trillion yen. Japanese retail sales fell 0.8 percent in April compared with a year earlier against a forecast of 0.2 percent drop.

By the end of the week, the Nikkei 225 added a healthy 1.3 per cent overnight, cementing its best week for the month. Nikkei, and yen, strength was attributable to data showing Japanese industrial production rose by a seasonally adjusted 3.3 per cent in the year to April.

Unadjusted the rate was 8.5 per cent. Household spending by salaried workers rebounded by 9.3 per cent in real terms on an adjusted basis. The recovery of the equity market is attributable to renewed confidence that the Japanese economy is becoming well established on a recovery path.

Range for the week: 108.00 - 113.00

Sterling

Sterling was the major mover for the week as it moved six big figures on the back of strong economic performance and the prospects of higher interest rates.

Many analysts now expect the next hike to come in June or July rather than August. Throughout the week sterling extended gains versus the greenback as persistently high oil prices and soft US data dragged the US unit lower against most of the major currencies.

British economy grew an unrevised 0.6 percent in the first quarter of this year, slightly below consensus expectations. A strong rise in household spending meant the figures did little to dampen expectations of several more UK rate rise this year.

By the end of the week, sterling's rally was hit by a speed bump after US manufacturing data allowed greenback to recover its footing after a weeklong slide.

Range for the week: $1.8000 - $1.8500