Dollar Traders Now Looking for 5.25% Rates

US Dollar

The US Federal Reserve raised interest rates for the fifteenth time by a quarter of a point today to 4.75 percent, the highest level in 5 years. The FOMC statement was also much more bullish than the market was expecting.

With Fed Fund futures originally showing only a small minority favoring 5.25 percent rates, the positive outlook on growth and concerns for rising inflation pressures has 5.25 percent the more likely top now. Newly installed Fed Chairman Ben Bernanke made his mark at today's meeting by changing the entire middle paragraph, or the meat of the statement.

The committee now believes that the weaker numbers that we saw in the fourth quarter of last year were due to temporary or special factors. We will be fascinated to hear what these "special factors" are since most of the talk of the slowdown was due to higher interest rates crimping the housing market or energy prices.

The Fed sees current growth as strong but expects it to moderate to a more sustainable pace. However in contrast to Greenspan's more concise comments on inflation, in true Bernanke style, the updated comments on inflation were far clearer.

The Fed said that even though the "run-up in the prices of energy and other commodities appears to have had only a modest effect on core inflation, ongoing productivity gains have helped to hold the growth of unit labor costs in check, and inflation expectations remain contained. Still, possible increases in resource utilization, in combination with the elevated prices of energy and other commodities, have the potential to add to inflation pressures."

The bottom-line is that the dollar is rallying on the more hawkish comments, especially since they reiterated that "further policy firming may be needed." This suggests that we are in store for two more rate hikes. However with a great deal of economic data still due for release this week and five central bankers scheduled to speak, we expect a lot more volatility in the days to come. A vertical rally in the dollar here on forward is far from certain.

Euro

To the surprise of the market, the German IFO survey jumped from an upwardly revised 103.4 to 105.4 for the month of March. The Euro screamed higher on the back of the release, confirming that the stronger number caught the market entirely off guard. Of course the Euro lost most of its momentum going into and on the back of the US interest rate hike.

The long stretch of stronger business confidence in Germany has continued for yet another month indicating that even though analysts or the so called "experts" are becoming more pessimistic about the economic outlook, businesses are not. In fact, business confidence is now at a 15 year high. The worry of analysts was that higher interest rates around the world would hurt growth and eventually also negatively impact German exports.

However, businesses may not be thinking as far forward and are instead basking in the benefits of a weak Euro. It certainly doesn't hurt that inflation is also stronger with M3 rising from 7.6 percent to a higher than expected 8.0 percent in February. Booming confidence and signs of inflation pressures provides more confirmation for the ECB to raise interest again in May.

Central bank President Trichet was on the wires this morning reiterating his view that interest rates remain at very low levels. Meanwhile, as expected, the FX market has made little mention of the strike in France that began today. The Eurozone economic calendar tomorrow is light, which means that EUR/USD traders will probably spend the day continuing to mull over today's US Federal Reserve rate decision.

British Pound

Although we saw weaker UK economic data today, hawkish comments from Bank of England Governor King helped limit losses in the British pound. Total business investment, which is not usually that significant given its infrequency, fell 0.9 percent in the fourth quarter. BoE Governor King however remains optimistic on growth and inflation.

Even though he doesn't think that consumer spending would return to the "heady days" of the past, he does believe that it is on path to return to the average growth of the past. Furthermore, he thinks that there is risk for inflation to overshoot the central bank's forecast, especially with oil prices now trading above $65 a barrel.

However, with the choice only between cutting rates or leaving it unchanged, the BoE is still on a clearly different path than the ECB. Tomorrow is an extremely busy day in the UK with GDP, current account, consumer credit, money supply, mortgage approvals and the CBI distributive trades report due for release. Most of the reports are expected to show improvements, which could be positive for the British pound.

Japanese Yen

Earlier gains in the Japanese Yen were erased as carry traders seeking more yield jump right back into the most popular carry trade of 2005. If a 4.50 percent interest spread was attractive, 4.75 percent will be even more so. Although fiscal year end repatriation still remains a predominant theme, with the US Federal Reserve meeting, carry is the bigger focus of the day.

The biggest story though is China, where news has surfaced that they had surpassed Japan as the world's largest holder of foreign exchange reserves. Official media reports are saying that China's reserves hit US$853.7 billion at the end of February, compared to Japan's US$850.1 billion.

To clarify, this is total reserves and not US reserves. It is estimated that China holds 70 to 80 percent of its reserves in dollars, which means that they have approximately $650 billion dollar denominated reserves. Japan on the other hand, is said to have over $800 billion in dollar reserves.