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Could the Reserve Bank of Australia Really Raise Interest Rates?

- US Dollar: Time to See How the Outlook Stacks Up - Could the Reserve Bank of Australia Really Raise Interest Rates? - Euro: Inside Day Signals a Potential Break

DailyFX Fundamentals 02-04-08

By Kathy Lien, Chief Strategist of

– US Dollar: Time to See How the Outlook Stacks Up
– Could the Reserve Bank of Australia Really Raise Interest Rates?
– Euro: Inside Day Signals a Potential Break

US Dollar: Time to See How the Outlook Stacks Up

Last week the focus of the currency market was on the US economy and interest rates. The Federal Reserve lowered the Fed funds rate by 50bp and two days later, the market learned that the US economy reported that 17k jobs were lost in the month of January, the first net job loss in 4 years. This week, the focus will shift away from the health of the US economy onto where US interest rates are headed compared to the rest of the world. Three central banks are meeting this week and three vastly different outcomes are expected. The Reserve Bank of Australia is forecasted to lift interest rates by 25bp to 7.00 percent and if they raise rates, they would be the last ones standing. When compared to the 125bp that the US Federal Reserve shaved off its own interest rate last month, it is clear why the US dollar has fallen to a 2.5 month low against the Australian dollar. A rate hike by the RBA would send the currency back towards its multi-decade high of 94 cents. The Bank of England on the other hand is expected to cut interest rates but if they fail to give the market what it wants, which is a quarter point interest rate hike expect a quick sell-off in the US dollar against the British pound. The European Central Bank on the other hand will be holding interest rates steady for the eighth consecutive month. As long as they retain the same degree of hawkishness, EURUSD losses should be limited. Factory orders were released this morning and even though they were slightly weaker than expected, the growth in orders was the strongest in 5 months. Service sector ISM will be out tomorrow. Like the manufacturing sector, growth in the service sector is expected to have slowed in the month of January. ISM should not be as market moving as it usually is because non-farm payrolls have already been released and the employment component of ISM is typically seen as a leading indicator for non-farm payrolls.

Could the Reserve Bank of Australia Really Raise Interest Rates?

The Reserve Bank of Australia will be announcing their monetary policy decision this evening and their announcement could set the tone for the entire market this week. If the RBA really raises interest rates not only will the Australian dollar rally, but we could see a nice run in carry trades as well. With everyone talking about global growth slowing, a rate hike from the RBA would mean that at least this central bank feels that their economy can handle tighter monetary policy. Based upon the 6 day rally in the Australian dollar, traders seem to agree. Of the 27 Economists surveyed by Bloomberg, every single one is calling for a quarter point rate hike. The sheer reality of 7 percent interest rates would send capital flooding into Australian dollars. Traders however need to be careful because everyone has jumped on the quarter point rate hike bandwagon, which means that if they do not raise interest rates, the currency will plunge quickly and sharply. Australian retail sales are expected to be released at the same time as the RBA rate decision, which means that it will be overshadowed by the monetary policy announcement. The December trade balance was released this morning and rising exports helped to narrow the deficit from 2.2B to 1.9B. Meanwhile the Canadian dollar also strengthened while the New Zealand dollar lost ground. No economic data was released from either country.

Euro: Inside Day Signals a Potential Break

The recent price action of the EURUSD suggests that we will see a breakout in the currency pair in the very future. ECB President Trichet shares the limelight with three other central bankers this week and the press is already talking about whether the central bank governor will back off his threat of higher interest rates. According to this morning’s producer price index, inflationary pressures remain a big problem as PPI rose from an annualized pace of 4.2 percent to 4.3 percent. Eurozone retail sales and service sector PMI are due for release tomorrow. Strong spending in France suggests that spending in the overall region may not slow as much as the German numbers suggest. Like manufacturing PMI, we expect service sector activity in the Eurozone to hold steady in the month of January.

British Pound Rebounds but Don’t Expect the Rally to Last

The British pound rebounded today but we do not expect the rally to last. The move is likely to just be corrective because UK economic data remains weak while the Bank of England is expected to lower interest rates on Thursday. The housing market remains the most vulnerable part of the UK economy and today’s drop in construction sector PMI and HBOS prices confirm that conditions in the sector remain difficult. Service sector PMI is due for release tomorrow and troubles in financial sector should limit any acceleration in activity. The UK times reports that the shadow monetary policy committee (MPC) which meets under the auspices of the Institute of Economic Affairs voted 5 to 4 for a rate cut. Their voting record has been a good leading indicator of actual MPC decisions.

Carry Trades Up, Dow Down

Once again carry trades and the Dow moved in opposite directions. For most of the US trading session, carry trades lingered near their highs whereas the Dow Jones Industrial Average weakened with every passing hour. The correlation between carry trades and US equities continue to break down as buying one no longer means buying the other. Risk aversion is still a problem and traders may simply be recycling money that is parked in local currencies. Meanwhile there is no Japanese economic data due for release until tomorrow night. If the Reserve Bank of Australia raises interest rates tonight, we expect a nice rally in carry trades.