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Dollar Action Hinges Upon Fed’s ?Measured? Statement

By Kathy Lien
21 March 2005 16:29 GMT

EURUSD

The dollar has strengthened ahead of tomorrow's FOMC rate decision.  With Japan closed for trading overnight, liquidity has been comparably thin and as a result, a larger more exaggerated move ahead of this week's most pivotal event is not surprising.  Loose budget rules listed in the EU's new Stability and Growth Pact gave dollar bulls another good reason to dump the single currency.  The former breakdown of the Stability and Growth Pact was a primary result of too many countries escaping penalties despite repeatedly breaching the Pact's budget deficit limitations.  The revised Pact now contains an escape clause for those countries that are going to breach the deficit, which should make no difference because all it does is make it within the law to break the rules and possibly even endorse irresponsible fiscal policy.  For a governing authority to be respected, they must not be afraid to uphold harsh rules and not accede to the individually motivated pressures of the parties under its rule.  The failure of the ECB to do so will only hurt the confidence that have been built up in the euro over the past 6 years.  Meanwhile the markets easily overlooked the comments by ECB officials in light of bigger developments.  In an interview with Reuters yesterday, Mersch said that the ECB "is only considering to keep rates stable or raise them. It doesn't plan a rate cut."  ECB Noyer on the other hand, confirmed that euro reserve "diversification is (already) underway." 

USDCHF

According to Bloomberg, 96% of economists surveyed expect the Federal Reserve to raise rates by a quarter of a point on Tuesday from 2.50% to 2.75%. Taking a look at how the data stacks up, we see broad improvements, but also the possibility of risks ahead.  Since the last FOMC rate decision in February, non-farm payrolls have increased from 132k to 262k, average jobless claims have fallen, the housing sector continues to outperform expectations, while consumer spending persisted.  Yet, not everything has been rosy in the US.  Since the last meeting, the data indicates that durable goods orders contracted, the trade balance continued to balloon, wage growth remained stagnant during the month of February while oil prices hit an all time high on March 16th.  Although most US data showed a gradual trend of economic improvement in the US, a lot of the indicators also fell short of expectations.  Therefore, the risk for this upcoming meeting is not whether the Fed will raise rates (with near certainty, they are expected to do so), but instead whether the Fed will modify their statement in any meaningful way to reflect a more hawkish bias.  Inflation is on the rise, but the increase is primarily due to higher energy prices, which poses a major risk for consumer spending.  As a result, the verdict on what the Fed will do is still unknown, with many economists disagreeing on the Fed's possible actions.  Based upon today's price action, it appears that traders are positioning for a possible removal of the phrase "measured" from the statement.  A failure to do so could see the euro trade back above 1.33 tomorrow afternoon or Wednesday. 

GBPUSD

The British pound is one of the biggest movers in the market today, down 1.2% or 280 pips against the dollar.  This is a big week in UK-land, with inflation, current account and GDP data on the table.  We start tomorrow off with the consumer and retail price indices.  The rebound in oil during the month of February is expected to increase price pressure.  A hawkish tone could help the pound rebound after the FOMC rate decision related dollar rally has passed over.  The MPC minutes from this month's earlier meeting could indicate that more than one member voted in favor of a rate hike. The more members that are in favor of another tightening, the higher the likelihood of a preemptive move by the Bank of England.   The UK also announced changes to the basket of products that they track in the consumer price index.  Reflecting changing tastes, out goes slimming drinks and dumbbells and in comes frozen chicken nuggets and gas barbeques.

USDJPY

The dollar has gained strength against the Japanese yen for the third consecutive trading day.  With the markets closed for the Vernal Equinox Holiday, USDJPY has been led higher solely by dollar optimism ahead of tomorrow's rate decision.  Much like Friday, the primary focus today is China and we do not want to lose sight of possible budding developments.  On Friday, we wrote about how the government is developing an "internal" inter-bank system to get their local banks educated on making markets in some of the more liquid currencies.  Today, the market is circulating rumors that an article in the Beijing Daily Newspaper indicates that China has decided to "drop its U.S. dollar peg and change to being pegged to a basket of eight foreign currencies." It also reported that the PBoC "will gradually exit from daily forex transactions and that "the band within which the Renminbi exchange rate floats may be expanded to 0.6% or 1.0% from the current 0.3%." Some are saying that this could happen as early as May.  If this is truly the case and these rumors prove to be true, then a more official revaluation announcement may be right around the corner.

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21 March 2005 16:29 GMT