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Euro: Inflation vs. Growth

- Fed to Pause in June, But Don't Rule Out More Rate Cuts - Euro: Inflation vs. Growth - British Pound Presses Higher

DailyFX Fundamentals 05-22-08

By Kathy Lien, Chief Strategist of

Fed to Pause in June, But Don’t Rule Out More Rate Cuts

The US dollar weakened significantly this past week as oil prices skyrocketed and stocks plummeted. Today however was a day of recovery with stocks and the dollar rebounding and oil prices easing. Whether this recovery turns into something more meaningful remains to be seen since this morning’s US data contained underlying weakness. More specifically, even though jobless claims dropped to the lowest level in four weeks, continuing claims drifted higher. House prices also fell by the most in 17 years as rising mortgage costs, tighter credit and growing inventory depresses the real estate market. Existing home sales are due for release tomorrow and even though housing starts and building permits rebounded last month, there is decent chance that sales of pre-owned homes will decline. Over the past few weeks, there have been reports that deals were thwarted by banks reducing or freezing home equity lines. The US economy still faces many risks and the Federal Reserve admits that the unemployment rate could rise significantly in the coming months. Even though the Fed will pause in June, they could resume their rate cuts if the economy continues to slow. The oil spikes of 1973, 1979 and 1990 all led to quarterly contractions in GDP (How Does an Oil Crisis Impact the US Dollar?) and all of the recessions in the past 35 years have been associated with oil shocks. Why should the impact of rising oil be less severe this time around? Since April, crude prices have increased 35 percent. Although GDP growth is already slowing, it has yet to contract and we believe that it will just be a matter of time before it does so. Back in the 1990s, the Fed took a break from cutting rates like they are expected to do in June, but they quickly resurrected their rate cuts as the economy slowed. Of course, interest rates are much lower now than they were back then, but if growth does not pick up, another rate cut could be right around the corner.

Euro: Inflation vs. Growth

Hawkish comments from the European Central Bank and stronger economic data has helped to strengthen the Euro. However we are skeptical about the improvement in German business confidence given the weakness in other manufacturing sector data. This morning, we learned that Eurozone industrial orders dropped 1.0 percent in the month of March. This confirms the prior weakness seen in reports of German industrial production and factory orders. The only explanation is that this data is old and manufacturing conditions have improved materially since March. Tomorrow’s PMI reports will shed more light on current conditions in the service and manufacturing sectors. If there is a drop in the PMI reports then our skepticism about the overly optimistic bias of German businesses is validated. If service and manufacturing activity actually accelerate, the EUR/USD stands a chance at retesting the 1.60 level. ECB officials on the other hand continued to harp on inflationary pressures; Weber warned that central banks cannot lose focus on inflation.

British Pound Presses Higher

The British pound and the New Zealand dollar were the only currencies that managed to strengthen against the US dollar today. Better than expected economic data validated the market’s belief that the central bank will remain on hold for the foreseeable future. Although consumer spending declined for the second month in a row, the drop was not nearly as bad as the market had forecasted. The CBI industrial trends survey also rebounded from -13 to -10, reflecting an improvement in manufacturer sentiment. Adding to the inflationary pressures that the UK already faces, according to the CBI survey, manufacturers are expected to raise prices over the next three months. The likelihood of higher consumer prices is yet another reason why UK rates will remain unchanged. The preliminary report for first quarter GDP is due for release tomorrow. No revisions are expected to the prior estimate for 0.4 percent quarterly growth and 2.5 annualized growth.

New Zealand Dollar Rallies on Tax Cut, Australian and Canadian Dollar Gives Back Gains

With commodity prices easing, the Australian and Canadian dollars have given back their gains. Economic data was mixed providing little direction for the commodity producing countries. In Australia, consumer inflation expectations for the month of May continued to grow, which validates the hawkish minutes from the Reserve Bank’s most recent meeting. Despite today’s retracement, we believe that the Australian dollar could reach parity with the US dollar in the coming weeks. Canadian retail sales on the other hand were weaker than expected as sales of clothing and accessories declined. The slowdown in the US and the severe winter weather has taken a big toll on consumer spending. The New Zealand dollar on the other shot upwards following the tax cuts announced by the Prime Minister. With the economy growing at the slowest pace in 10 years, the New Zealand government has delivered their first tax cut since 1999.

Japanese Yen Crosses Rebound
The recovery in the Dow has helped to strengthen all of the Japanese Yen crosses. Economic data from Japan was mixed with the merchandise trade balance narrowing and the all industry activity index increasing. The rise in oil has boosted the country’s import bill but at the same time, it has yet to stifle the Japanese economy. As a major importer of oil, Japan is very vulnerable to the rise in crude, but the latest economic data suggests that higher energy prices have not had a material impact on the Yen. Their recovery is still fragile, which is why the IMF warned Japan against raising interest rates in the interest of preserving their expansion.