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Euro: Has Inflation Hurt Businesses?

- US Dollar: First Oil Summit, then Fed Meeting - Can the British Pound Extend its Gains?

DailyFX Fundamentals 06-20-08

By Kathy Lien, Chief Strategist of DailyFX.com

US Dollar: First oil summit, then Fed meeting

The US dollar faces two major event risks next week – the Oil Summit in Jeddah and the FOMC rate decision.

This weekend, Saudi Arabia will be hosting an Oil Summit in the city of Jeddah, located on the coast of the Red Sea.

They have invited executives from oil companies, leaders of nations and the world’s largest oil producers.

Oil is the world’s biggest problem and the market is hoping that Saudi Arabia can drive down the price oil.

However this hope may be overly optimistic since the market has failed to respond to Saudi Arabia’s prior announcement about increasing production.

With Venezuela, one of the most important members of OPEC absent from meeting, we do not expect any groundbreaking results. Most OPEC nations including Iran do not believe that increasing supply is the solution because their belief is that oil is being primarily driven higher by speculation.

The Saudi Arabia meeting alone will not cause a long term top in oil but how oil trades after the meeting will certainly impact the US dollar.

On Wednesday, the Federal Reserve will be making a monetary policy announcement. After cutting interest rates by 325bp since August, the Fed is expected to pause. With the pause should come hawkish comments that pave the way for an interest rate hike before the end of the year.

The debate in the markets right now is whether a rate hike will come before or after the US Presidential elections in November.

Currently, Fed fund futures are pricing in a strong likelihood of a September rate hike and the tone of the FOMC statement should shed more light on the Fed’s urgency to contain inflation.

Hawkish comments will be positive for the US dollar while neutral comments will be very dollar negative. Aside from the FOMC rate decision, consumer confidence, durable goods, new and existing home sales, the final release of first quarter GDP, personal income and personal spending are due for release.

Not only will it be a big week for the US dollar, but the FOMC statement could set the tone for trading for weeks to come.

Euro: Has inflation hurt businesses?

The Euro strengthened against the US dollar as producer prices in Germany grow by the fastest pace in nearly two years.

It is actually a bit surprising that the Euro still responds to stronger inflationary pressures which is nearly a given considering that food and energy prices continue to climb.

ECB member Bini Smagh warned this morning that rates will have to increase because if ‘inflation is left to creep up, the cost of bringing it down later will be even higher.’

The focus next week for the Eurozone will be how inflation has impacted growth. The week starts off with the German IFO report, and the service and manufacturing PMI numbers. Then on Friday, we are expecting the retail PMI numbers and current account.

This past week, German investor confidence dropped to a 15 year low. The recent drop in consumer spending as well as the threat of an interest rate hike next month should also weigh on business confidence.

Meanwhile, Switzerland also reported a sharp increase in import prices but apparently that was not enough to convince the Swiss National Bank to raise interest rates. Next week, Switzerland will releasing the UBS consumption index and KoF leading indicators.

Can the British Pound extend its gains?

The British pound has had a great week thanks to broad dollar weakness and strong economic data.

The UK retail sales report has raised a lot of questions as to how much longer the Bank of England can remain on hold.

Earlier this week, Bank of England Governor King warned that inflation could hit 4% this year, which is two full percentage points higher than their inflation target.

The only thing holding the BoE back from raising interest rates now is growth, but if growth is stabilizing, then a rate hike may be just around the corner.

Unfortunately there isn’t a lot of data to help the British pound next week. The calendar is relatively light except for a few reports on house prices, the final GDP numbers for the first quarter and current account.

Commodity Currencies: A mixed bag

The performance of the commodity currencies were mixed with the Canadian and New Zealand dollars giving back their recent gains while the Australian dollar gained strength for the sixth consecutive trading day.

Retail sales in Canada grew by 0.6% in April, which is the fifth monthly increase in consumer spending in the past seven months.

Part of the rise was driven by gasoline receipts, but consumers also spent more on clothing and general merchandise. However the knee jerk rally in the Canadian dollar was quickly erased on fears that Canada’s Supreme Court would reject the privatization of BCE Inc, Canada’s largest phone company. This was eventually approved but not until the end of the US trading session.

In the week ahead, New Zealand is the only commodity producing country with any meaningful economic data, which means that the NZD/USD is in play; the current account balance, GDP and the trade balance are due for release.

Relationship between carry trades and the Dow has broken

Over the past few weeks, there has been practically no correlation between the moves in carry trades and the move in the Dow.

This is a big departure from a year or even just a few months ago when risk appetite had the same impact on the currency and the stock market.

On Friday, the Dow dropped over 200 points and yet EUR/JPY and CHF/JPY rallied. Since the middle of May, the stock market index has tumbled more than 1000 points and yet pairs like AUD/JPY has climbed 400 pips while EUR/JPY has climbed 500 pips during the same period.

This suggests that the sell-off in stocks may not be entirely due to risk aversion.