Complex Made Simple

Euro Breaks Higher as Market Shifts Focus to ECB

- Is the Dollar Rally Over? - EUR/JPY Hits Record High

DailyFX Fundamentals 06-25-08

By Kathy Lien, Chief Strategist of DailyFX.com

Is the Dollar rally over?

The Federal Reserve left interest rates unchanged at 2% and upgraded their degree of hawkishness but unfortunately for dollar bulls, the Fed was not hawkish enough (Detailed Take on the FOMC).

What currency traders came to realize was that even though the Fed could still raise interest rates in September, the ECB will beat them to them punch.

Federal Reserve members are in no rush to show their cards because time is on their side.

With two non-farm payrolls and multiple inflation reports before the next Fed meeting, the US central bank will get a much better sense of whether US consumers and businesses can handle a rate hike.

In the meantime the dollar may continue to let off some steam, particularly against the Euro.

Non-farm payrolls and the European Central Bank meeting are both scheduled for the same day next week, which could give us two reasons to sell the US dollar.

However any further weakness should just be a bump in the road for the US dollar because the ECB has already forewarned the markets that the July rate hike may be one-off.

Therefore the focus will shift back to the Federal Reserve, whose next move will be a rate hike. If inflation refuses to ease over the next few months, the Fed may be forced to tighten monetary policy more than once.

In that case, they could be perceived as more hawkish than the ECB, which would help the dollar recover. This is of course assumes that economic conditions do not get progressively worse over the next two months and inflation does not suddenly drop.

Durable goods orders and new home sales elicited nothing more than a yawn as both numbers came out very close to expectations.

The final figures for first quarter GDP, jobless claims and existing home sales are due for release tomorrow. All three pieces of data are expected to be dollar bullish with GDP predicted to be revised higher and existing home sales expected to rebound.

Euro breaks higher as market shifts focus to ECB

The currency pair that had the most significant reaction to the FOMC announcement was the EUR/USD. With the Fed meeting behind us, the ECB is the only central bank expected to make any changes in interest rates over the next two months.

ECB President Trichet said this morning that there is an acute risk of wage price spiral and reminded the market that they could raise interest rate 25bp at the next meeting.

The ECB’s intentions should be quite clear and with a little more than one week to the ECB meeting, the market may continue to bid up Euros against US dollars simply because one central bank will be raising interest rates while another remains stationary.

This would widen the gap between Eurozone and US interest rates from 200 to 225bp in the Euro’s favour.

In the meantime, good news is still being reported from the Eurozone. Industrial new orders jumped 2.5% in the month of April, well above the market’s -0.5% forecast.

German import prices are due for release tomorrow and given the rise in oil prices last month, we expect import prices to continue to edge higher.

The ECB also has no problems with further Euro strength. According to ECB member Wellink, the equilibrium rate for the Euro is around 1.60. The central bank wants the Euro to rise because they know it will help to ease inflationary pressures.

EUR/JPY hits record high

The Dow Jones Industrial Average was up more than 100 points following the FOMC rate decision. Even though it erased all of those gains, the Japanese Yen crosses ended the US trading session near its highs.

EUR/JPY was the best performer. The currency pair hit a record high thanks almost entirely to Euro strength.

With central banks around the world turning hawkish, carry trades are back in the limelight. The Japanese merchandise trade balance was released last night.

It was stronger than expected as accelerating shipments to Asia helped to offset softer demand from the US and Europe. The corporate service price index also accelerated, reflecting growing inflationary pressures.

There is no significant Japanese data due for release this evening, but things will pick up tomorrow when retail sales and consumer prices are scheduled for release.

US Dollar weakness sends Australian, New Zealand and Canadian dollars edge higher

Despite a drop in commodity prices, US dollar weakness has sent the Australian, New Zealand and Canadian dollars higher.

The only piece of economic data released from the three commodity producing countries was New Zealand, who reported the lowest level of consumer confidence in the history of the series, which was created back in 1993.

Over the next 24 hours, we are expecting the New Zealand current account balance, and the Australian Conference Board index of leading indicators. Both numbers have a chance of surprising to the upside which should help to fuel further gains in the Aussie and Kiwi.

UK retail sales may reverse

The British pound was at the whim of the US dollar and Euro today with the CBI Distributive trades survey failing to motivate any meaningful action in the currency.

Last month, retail sales were very strong, but next month, consumer spending could falter. Even though the CBI retail sales index was less negative than the last two months, sales expected for the month of July plummeted.

In other words, retailers do not believe that the strong pace of growth reported last month can be repeated next month.

Like the US dollar, the pound has fallen victim to the prospect of higher interest rates in the Eurozone and stagnant rates in the UK.

Although inflation is more than a full percentage point above the Bank of England’s 2% target, the lack of definitive strategy on interest rates is hurting the British pound.