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ECB Rate Decision: Biggest Event Risk Next Week

- US Dollar: Be Careful of What You Buy - Could the Bank of England Cut Interest Rates?

DailyFX Fundamentals 05-02-08

By Kathy Lien, Chief Strategist of DailyFX.com

US Dollar: Be careful what you buy

Since the beginning of the week, we have warned of a potential dollar rally.

At the time, we were basing our argument primarily on the flip in the FXCM Speculative Sentiment Index, technicals and a turn in Eurozone economic data. However now we can add to that list a turn in US economic data as well.

Throughout this past week, there have been a number of upside surprises in the US releases including today’s non-farm payrolls report, first quarter GDP, Chicago PMI, and manufacturing ISM.

Although we do not believe that the worst is behind us, this stability does indicate that the pace of the slowdown in the US economy has moderated.

This is the first time in four months that the non-farm payrolls report beat expectations, falling by -20k instead of the forecasted drop of -75k.

Although the manufacturing sector continued to cut jobs, the service sector actually added jobs for the third month in a row, suggesting that Monday’s service sector ISM report may not be that bad.

For the Federal Reserve, this is a welcome improvement because it validates their hawkish comments and indicates that their efforts to date are mitigating some of the risks to economic activity.

In addition to the NFP report, the Federal Reserve also announced additional liquidity measures. They increased the size of their Term Auction facilities from $50bn to $75bn, increased their swap lines with the ECB and SNB as well as expanded the collateral that they are willing to take to include AAA-rated asset backed securities.

Up until today, the Fed was primarily accepting residential and commercial mortgage backed securities. For the most part, we expect a continued recovery in the US dollar, however traders need to be careful of what they buy.

In terms of US data, the economic calendar next week is light with only service sector ISM, pending home sales and the trade balance due for release.

The US dollar is nearing resistance against the Japanese Yen and there is little evidence to suggest that the currency pair will head much higher. The same can be said for the US dollar against the Australian dollar.

Strong retail sales could continue to send the AUD/USD higher. However, the outlook is slightly different for the dollar against the Euro, British pound or New Zealand dollar. Fundamentals and technicals point to further losses for these three currencies against the US dollar.

ECB Rate Decision: Biggest event risk next week

With no major US economic data on the calendar next week, the biggest event risk is the European Central Bank interest rate decision.

The question before the markets is whether or not the ECB will acknowledge the recent deterioration in Eurozone economic data and as a result, take a step back from their staunchly hawkish monetary policy.

Unlike the US, Eurozone economic data has primarily surprised to the downside this week. German retail sales dropped for the second month in a row, the employment rate ticked higher, Eurozone industrial confidence deteriorated, Retail PMI across the region contracted while consumer prices showed a surprising drop last month.

Manufacturing PMI numbers for the month of April was revised slightly lower for the Eurozone due to a slowdown in France and Italy.

However the only problem is that in recent weeks, members of the European Central Bank have not wavered. Today, ECB member Erkki Liikanen, the governor of the Bank of Finland, reminded the markets that controlling inflation is key. The uncertainty surrounding the ECB interest rate decision should lead to some interest volatility following Trichet’s press conference at which everyone expects interest rates to be left unchanged.

Could the Bank of England cut interest rates?

Like the European Central Bank, the Bank of England will also be delivering a monetary policy decision next week and they are expected to leave interest rates unchanged.

The difference for the BoE is that inflationary pressures in the UK are slightly better while economic conditions are slightly worse.

This morning’s HBOS house prices and construction sector PMI report both fell short of expectations. This explains why Prime Minister Gordon Brown suffered a humiliating defeat at the polls on Thursday night.

Everyone is looking for the Bank of England to do more, but it remains to be seen whether they will actually deliver.

The BoE has surprised the markets in many instances which means that cutting rates when the markets doesn’t expect them to would not be out of character.

However judging from the minutes of the last monetary policy meeting, there may not be many supporters for a rate cut. The MPC voted 6-2-1 for the quarter point cut in April with six members supporting the move, two members voting for rates to be left unchanged and one member voting for a 50bp rate cut.

Commodity currencies in focus next week

The Canadian, Australian and New Zealand dollars will be in focus next week. Not only are employment reports due for releases from all three countries, but the Reserve Bank of Australia will also be meeting to decide on interest rates.

The market expects the labour markets to slow which is the reason why the RBA will leave interest rates unchanged. Retail sales were released this morning and even though they were stronger than expected, the impact on the Australian dollar was limited.

We expect the Australian dollar to continue to rise on the belief that service sector PMI and the trade balance will be Aussie positive.

Yen crosses rally on risk appetite

The Japanese Yen crosses all rallied against the US dollar as risk appetite returns to the market following the better than expected non-farm payrolls report.

All of the Yen crosses are higher, led primarily by the rally in USD/JPY. Whether or not these moves can continue into the coming week will depend upon the market’s risk appetite because there are Japanese or US economic releases on the calendar.