US interest rates to rise later this month

Euro

The dollar kicked off the week on a subdued tone against the euro after a lethal attack in Saudi Arabia caused some investors to worry about higher oil prices and increased violence in the Middle East.

The attack by suspected Qaeda militants, in which 22 civilians were killed, was the second strike in a month aimed at destabilising the world's top oil exporter.

As the week progressed the dollar failed to post substantial gains on upbeat U.S. economic data as surging oil prices clouded the outlook for U.S. economic recovery.

The Institute for Supply Management said its index of national factory activity rose to 62.8 in May from 62.4 the prior month, beating expectations of a small decline to 62.0. A measure of factory employment jumped to the highest level in 31 years as the nation's factories marked a full year of recovery.

Furthermore, the commerce department said the construction spending jumped more than expected in April as rising mortgage interest rates spurred a rush to build. Meanwhile, in Euro land manufacturing put on its strongest performance in over three and half years last month as a weaker euro helped boost exports and consumer demand improved in France.

The Reuters Eurozone Purchasing Managers' Index, which measures business activity in manufacturing, rose from 54.0 in April to 54.7 in May, its highest since October 2000 and confounding economists who predicted a fall to 53.8.

The dollar found some support against the euro ahead of an OPEC meeting, which was expected to take some heat of steaming oil prices. Moreover, the dollar benefited after the United Arab Emirates, a member of the OPEC, said it would release an extra, 400,000 barrels a day this month, on the heels of 700,000 barrels per day from Saudi Arabia.

However, the dollar's gains were short lived even after OPEC decided to raise oil output by two million barrels a day. In addition, U.S. Labour department said first time claims for state jobless benefits slipped 6,000 to 339,000, which was above the 336,000 expected on Wall Street.

In Eurozone as expected the ECB left the interest rates unchanged at 2 percent for a 12th straight month. ECB President Jean-Claude Trichet told reporters that in addition to the view that the economic recovery in euro zone has strengthened, the bank sees inflationary pressures over the short-term. His comments dampened speculation of the ECB cutting rates and provided extra support for the euro.

At the end of the week dollar failed to take advantage of much awaited U.S. non-farm payroll data, which came at the high end of expectations but still disappointed investors who had bet that a powerful surge in job creation would boost demand for dollars.

The U.S. economy added 248,000 new non-farm jobs in May, above the median estimate of 216,000 in a Reuter's survey. April's data were also revised sharply upward to 346,000 new jobs from 288,000 as first reported, surprising the market. The unemployment rate stayed steady at 5.6%.

Meanwhile, Fed Governor Donald Kohn said the U.S. economy was not threatened by a wave of worsening inflation that would require a sharp rise in rates, reinforcing current thinking that any rate increases will be gradual.

The financial markets are looking forward to next week's data on U.S. producer prices to see whether it might bolster the case for a larger rate hike than currently expected. The trade deficit is expected to shrink to $44.9 bln after widening in April as imports rose.

Range for the week: $1.2150 - $1.2450.

Japanese Yen

At the start of the week, dollar dropped to a three-week low against the Japanese yen as it came under pressure from geopolitical concerns and speculation that a U.S. rate rise could be delayed.

Furthermore, yen was underpinned after Reuters / Nomura / JMMA Purchasing Managers Index (PMI) rose to 56.2 from 55.9 in April, just shy of the survey high of 56.4 set in November. Moreover, Japan's Ministry of Finance said it did not intervene in the foreign exchange market in May, the second consecutive month it stayed out of the market after spending a record amount last year to stem the yen's rise.

However, yen failed to hold to its gains, hurt by upbeat data on U.S. manufacturing and construction spending and a view that rising oil prices could curb global demand for Japanese exports. Japanese companies are almost entirely dependent on imports for their oil needs.

Economic indicators transmitting further signs of a strengthening economy did little to help the yen. Government data showed that Japanese companies increased spending on plant and equipment by 10.2 percent in the January-March quarter from the same period a year earlier. Capital flows data showed that foreign buyers returned to the Japanese stock market after three weeks of heavy selling.

Range for the week: 109.00 - 112.00

Sterling

Sterling was well supported against the dollar as upbeat UK retail and manufacturing surveys raised the chance the Bank of England would hike rates soon.

The Confederation of British Industry's distributive trades survey showed British retail sales rose at their fastest annual pace in more than two years in May. In addition, the CIPS / Reuters survey showed British manufacturing growth and the prices firms charge for their goods rose faster in May.

The index rose for the third month to 55.6 in May, its highest level since January and well above the 50.0 mark that separates the expansion from contraction. Furthermore, manufacturers added staff in May, the fifth month net gain in the past six months, pushing up the employment index to 52.8, its best reading since June 1997.

British lending data showed mortgage lending up by a record amount in April and consumer credit rising, although by less than expected, suggesting three interest rates hikes since the start of November have not yet put the brakes on a booming housing market.

Sterling ended the week underpinned as expectations ran high that the Bank of England will widen the US-UK rate differential for a few brief weeks when it announces its rate decision next Thursday, a prospect that should keep the pound well supported until then.

Next week, Bank of England meets on June 10th and the financial markets expect a 25bp hike.

Range for the week: $1.8200 - $1.8500