Euro Holds Gains As Market Sentiment Shifts

The EUR/USD continued to hold the 1.2600 level in quiet Asian and European sessions absent of any new developments, as the currency markets continued to digest Fed Chairman Bernanke's remarks from yesterday's testimony in front of US Congress.

With Bernanke presenting a neutral rather than hawkish view, the market has started to pare down expectations about any future Fed rate hikes beyond the expected bump of 25bp to 5.5% at the August FOMC meeting. The key take away from yesterday is that the Federal Reserve appears to be nearing the end of the interest rate hike cycle started in 2004.

This slow change in policy comes despite the relatively "hot" results from inflationary gauges such as yesterday's core CPI report which showed prices rising 2.6% on a year over year basis. The Fed is clearly beginning to worry about the slowdown in US economic demand as evidenced by latest economic data points such as the tepid results of the most recent Retail Sales report and the significant backup in the housing market where inventories have reached record levels of more than 3 million units.

Furthermore with US mid-term elections scheduled for November, the Fed is very likely to stand aside during the last six weeks of the political season leaving it only with one additional opportunity beyond August to raise rates further. In short, with US economic growth slowing as the spread in interest rate differentials flattens and perhaps even begins to contract, dollar bulls will now face serious obstacles in trying to push the pair materially below the 1.2500 level for any extended period of time.

In Japan today the release of the BOJ minutes offered little fresh information vis a vis the near term direction of monetary policy and the yen continues to be hampered by the cautious attitude of Japanese central bankers, with EUR/JPY once again trading above 147.00 while GBP/JPY continues to hit multi-year highs reaching 215.75 in early London trade.

On the positive side Convenience store sales in Japan rose on a year over year basis for the first time in 24 months, providing yet more evidence that deflation is over. For now however yen bulls will receive no solace from strong economic results until monetary policy begins to adjust to the new inflationary reality.