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Bernanke Shifts Tone, Sending Dollar to Record Low against the Euro

Wednesday, 18 July 2007 21:40:48 GMT  |  Kathy Lien, Chief Strategist

• British Pound Breaks 2.05 on Dollar Weakness and Asian Buying
• Euro hits Record High of 1.3835

Bernanke Shifts Tone, Sending Dollar to Record Low against the Euro
To the surprise of the market, Federal Reserve Chairman Ben Bernanke shifted his tone ever so slightly in his congressional testimony on the economy and monetary policy.  Back in February, when he gave his last testimony, Bernanke said that the housing market was stabilizing but now he feels that the problems in housing could get worse before it gets better.  The Fed’s vocal concern about contagion indicates that “in their books” the economic environment has deteriorated enough to begin considering putting growth ahead of inflation.  For a central banker that wants to stake his reputation on fighting inflation, this is significant.  Bernanke also reminded us that the Fed’s primary focus is on core prices and not headline prices.  Even though oil prices are rising, he felt that unless we have another big jump, core prices could edge a bit lower.  The Fed cut their growth forecasts for 2008 to 2.5-2.75 percent from 2.75-3 percent and increased their unemployment forecasts from 4.5 percent to 4.75 percent.  The central tendency for core inflation was left unchanged at 2 to 2.25 percent for 2007 and 1.75 to 2 percent for 2008.  This indicates that they expect inflation to slow over the next year.  Today’s economic releases provide support to the Fed’s cautionary stance.  Headline consumer prices were stronger than expected, but core prices were right in line with expectations.  Even though the gain in core was slightly higher than the rise in May, it is only modestly so.  Starts increased but building permits hit a 10 year low, indicating that housing continues to be a problem.  Bond yields and the US dollar dropped on the back of Bernanke’s comments, but further dollar weakness could be limited by the fact at this point, the Fed can do little more than raise red flags. 

British Pound Breaks 2.05 on Dollar Weakness and Asian Buying
The British pound first broke the psychologically important 2.05 level against the US dollar in the middle of the Asian trading session.  Keying off of the stronger UK inflation data reported yesterday and the weaker US PPI numbers, Asian traders aggressively bought the GBP/USD, taking the pair up from 2.0490 to 2.0549 in a little more than an hour.  However once European traders came into the market, they began to take profits and initiate short positions.  The correction was exacerbated when the less hawkish Bank of England minutes were released; the GBP/USD eventually sold off to 2.0460.  Once Bernanke began to talk however, dollar selling resumed and the GBP/USD took off once again, ending the US trading session not far from the new 26 year high set overnight.  The reason why examining the price action is so important is because it tells us that today’s strength in the GBP/USD is driven almost exclusively by dollar weakness and not pound strength.  If anything, the Bank of England minutes signals that even if we do have another rate hike this year, it will not be until the latter part of the fourth quarter, at the earliest.  Yesterday we indicated that anything short of a 7-2 vote in favor of raising rates would be construed as dovish.  The rate hike earlier this month was supported by only 6 out of the 9 members.  The dissenting views amongst the monetary policy committee members indicate that as a whole, they are not in as much of a  rush to raise rates as the market may have initially thought.  This stance is supported by further slowing in average wage growth in the month of May.  Even though the number of people claiming unemployment benefits decreased, weaker wage growth could still hurt retail sales.

Euro hits Record High of 1.3835
We have long said that the direction of monetary policy is far more important than the level of interest rates and today, the move in the EUR/USD is a testament to that.  The currency pair climbed to a new record high of 1.3835 following less hawkish comments from the US central bank.  In an environment where the European Central Bank is pounding the table about the need to raise rates, the growing chance of a rate cut before a rate hike in the US is driving the dollar lower.  One would expect that the ECB would begin backing off given the recent appreciation in their currency, but instead of showing any signs of concern, Trichet warned today about that any attempts to influence the ECB would be in violation of the EU treaty.  This suggests that they are not willing to talk down the Euro and will only do so under their own terms.  ECB council member Garganas also said yesterday that he expects the central bank to raise rates further. 

Commodity Currencies Hit Fresh Highs on Dollar Weakness
Dollar weakness has sent the commodity currencies skyrocketing to new multi-decade highs, which have become a near daily occurrence for the Canadian, Australian and New Zealand dollars.  Gold and oil prices are up on the day which is helping, but most of the strength is coming from US dollar weakness since the data released from the three countries were actually bearish. Canadian consumer prices fell in the month of June, leaving annualized consumer prices at 2.2 percent while core prices remained flat.  Meanwhile Australian leading indicators weakened in the month of May, there was no economic data released from New Zealand.  The outlook for the currencies will continue to predominantly dependent upon US data.  Only Canada has the potential to move on its own accord with wholesale sales and international securities transactions due for release. 

Carry Traders Haven’t Given Up
Carry traders aren’t quite ready to give up yet.  Despite the Dow having been down over 100 points intraday, the highest yielding carry trade currencies still managed to end the day in positive territory.   The Dow also recuperated half of its losses which suggests that the rally could go on.  The only currencies that the Japanese Yen managed to rally against were the Euro, Swiss franc, US and Canadian dollars and for the most part, the damage was small.  Looking ahead, we expect carry trades to continue to track the Dow.

Written by Kathy Lien, Chief Strategist of DailyFX.com

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