Complex Made Simple

ECB Leaves Rates Unchanged, Expresses Concern about Growth

- Weak Dollar Hits Main Street - ECB Leaves Rates Unchanged, Expresses Concern about Growth - Bank of England Cuts Interest Rates to 5.25%

DailyFX Fundamentals 02-07-08

By Kathy Lien, Chief Strategist of

Weak Dollar Hits Main Street

The US dollar continued to strengthen today but to the rest of the world, it is losing its luster. With the dollar falling 13 percent against the Euro since the beginning of last year, Main Street is finally waking up to what Wall Street has known all along, which is that currencies matter. All over the news has been a story about how New York City vendors are beginning to accept other currencies in addition to US dollars. This is primarily due to the fact that the dollar has fallen significantly in value over the past year as NYC tourism hit a record high. However the impact of the dollar does not end there. As Fashion Week begins, buyers for some of the leading retailers in the US are shunning London catwalks and either staying domestic or heading to Paris instead. For the first time in 20 years, the fashion director of Barneys will be skipping fashion shows in London. The strength of the British pound and the weakness of the US dollar have made it very difficult for many designers to absorb the currency conversion. According to an executive VP of Neiman Marcus, “it’s generally the big brands who can do it.” Don’t expect this trend to disappear because it will be a very long time before we see a dollar be worth more than a Euro or British pound, if ever. With the Federal Reserve expected to lower interest rates by at least another 50bp over the next few months, the widening spread between US, Eurozone or UK rates should eventually trigger further dollar weakness. Initial jobless claims, pending home sales and the ICSC chain store sales all fell short of expectations. Following last week’s sharp rise, the latest jobless claims figure suggests that we could see another month of net job losses in the month of February. As for chain stores sales, the drop is fairly important ahead of next week’s US retail sales report. If consumer spending contracts for another month, the Federal Reserve may have no choice but to bring interest rates down to as low as 1 percent, dropping the US dollar one notch to become the second lowest yielding currency in the developed world.

ECB Leaves Rates Unchanged, Expresses Concern about Growth
The European Central Bank left interest rates unchanged today at 4 percent, but ECB President Trichet finally bowed to market pressures by recognizing that the resiliency of the Eurozone to slower US growth is cracking. More specifically, Trichet stressed multiple times that the risk to growth is to downside and uncertainty about market turmoil is usually high. Even though they are committed to preventing second round effects and to maintaining price stability, Trichet’s gloomy outlook sent the EUR/USD tumbling 200 points. In the short term, the comments will not satisfy Euro bulls, but we still expect the EURUSD to recover back above 1.45. Maybe not tomorrow, but certainly over the next few weeks as traders short dollars realize that it’s a dangerous trade with Eurozone interest rates 100bp higher than US rates with the spread growing. German factory orders dropped 2.0 percent in December which reinforces slower Eurozone growth. We expect tomorrow’s German industrial production and trade balance numbers to continue to reflect this trend. Meanwhile Switzerland will be releasing consumer prices. With EURCHF falling 800 pips during January, the strong franc is expected to drive down inflationary pressures. This will be encouraging for the Swiss National Bank who plans on leaving interest rates unchanged for the foreseeable future.

Bank of England Cuts Interest Rates to 5.25%
The Bank of England cut rates in line with expectations by 25bp to 5.25 percent, marking the second effort to make policy more accommodative since December. The central bank cited deteriorating prospects for global output growth and tightening credit conditions for consumers and businesses alike. While the Monetary Policy Committee did say that rocketing energy and food prices are “expected to raise inflation, possibly quite sharply,” the subsequent cooling effect on demand growth is anticipated to be enough to “return inflation to target in the medium term.” Essentially, the Bank of England is more concerned that slowing growth will bring inflation below target than they are concerned that inflation will accelerate out of control, suggesting that more rate cuts may loom on the horizon as long as economic data points to deteriorating conditions.

Commodity Currencies Give Back Gains, but Retracement Could be Temporary
The Canadian, Australian and New Zealand dollars all gave back some of their recent gains today on the back of carry trade liquidation. The Dow ended the US session up xx points, but sharp intraday volatility has weighed heavily on the commodity currencies. Gold and oil prices are higher and there was no major economic data released from any of these 3 countries. Canadian employment and housing starts are due for release tomorrow. The sharp rise in the employment component of IVEY PMI and a jump in building permits suggest that we should see bullish Canadian numbers.

Carry Trades Struggle Amidst Market Volatility
In the past, we have said that carry trades thrive when volatility is low, risk appetite is high and central banks around the world are raising interest rates. Unfortunately with the current market environment not satisfying even one of these qualifications, carry trades have struggled. USDJPY is trading near a one month high but pairs like EURJPY, GBPJPY, GBPUSD, AUDUSD and the NZDUSD all sold off today. The Dow was both up and down over 100 points today before settling up xx points. This type of intraday volatility is and will continue to wreck havoc for carry trades.