daily fundamentals

Dollar Reverses after FOMC Signaling that Traders Do Not Believe Fed Will Stay Hawkish for Long

Tuesday, 07 August 2007 21:10:55 GMT  |  Kathy Lien, Chief Strategist

• Dollar Reverses after FOMC Signaling that Traders Do Not Believe Fed Will Stay Hawkish for Long
• Reserve Bank of Australia Expected to Raise Interest Rates
• British Pound Slips Ahead of Quarterly Inflation Report

Dollar Reverses after FOMC Signaling that Traders Do Not Believe Fed Will Stay Hawkish for Long
It has been some time since we’ve seen this degree of volatility in the financial markets following an interest rate decision. As expected, the Fed left interest rates unchanged at 5.25 percent, but both the US dollar and the US stock market tanked on the back of the monetary policy statement.  The statement was as hawkish as it could be given current market conditions.  Although the Fed felt that the downside risks to growth have increased, they still believe a strong labor market and growing incomes will keep economic growth stable.  They also acknowledged that volatility in the markets have increased and credit conditions have become tighter, but at this point, the problems are not severe enough for them to stop worrying about inflation and start focusing on growth. The rollercoaster price action in the financial markets suggests that traders are still trying to figure out whether or not to believe the Federal Reserve’s attempts to calm the market.  The central bank clearly needs more evidence than the few bankruptcies and blowups that we have seen thus far to shift their tone.  Unfortunately there is never just one cockroach in the closet.  More adjustable rate mortgages will be repriced over the next 6 months, which means the risk of defaults will continue to rise.  Even if the Fed is right, the age of easy money is over and everyone will be far more careful about the degree of risk that they are willing to take.  Therefore don’t expect a rebound back to all time highs in the US stock market.  Instead, it is more likely that we see the US dollar slip back towards its record lows against the Euro.  Today’s Fed meeting was supposed to set the tone for trading for the remainder of the week.  At this point however, it seems that the market is more doubtful of the FOMC statement than anything else.  This makes the release of the minutes and any further Fed speak even more important. 

Reserve Bank of Australia Expected to Raise Interest Rates
Now that the FOMC meeting is behind us, the next interest rate decision is in Australia.  The Reserve Bank is widely expected to lift interest rates from 6.25 percent to 6.50 percent.  Consumer price growth in the second quarter was 2.1 percent, which is within their 2 to 3 percent inflation target.  However the prospect of higher inflation in the months to come will force the central bank to be proactive with raising interest rates.  Retail sales have been hot and businesses are becoming more optimistic.  The market has already priced in an 80 percent chance for a rate hike, so like the Fed meeting, the key focus will be on the RBA comments afterwards.  The market is actually not expecting the RBA to raise interest rates again this year.  The Australian dollar has weakened going into the RBA rate decision due to softer than expected construction sector PMI data last night.  The index dropped into contractionary territory, signaling that the housing market may have hit its peak.  The Canadian and New Zealand dollars are also weaker despite a continued rise in New Zealand’s ANZ commodity price index. 

British Pound Slips Ahead of Quarterly Inflation Report
The Bank of England will be delivering its Quarterly Inflation Report tomorrow.  Given market expectations for 6 percent interest rates by the end of the year, in order to satisfy market expectations, the BoE will have to be hawkish.  Economic data has been mixed.  Retail sales were weaker than expected in the month of June but the labor market tightened.  On a headline level, annualized consumer price growth slowed, but taking a look at just core prices, inflationary pressures actually increased.  At this point the UK economy could handle a year end interest rate hike, but the outbreak of Foot and Mouth disease brings with it new risks.  It is at an early juncture which means it may not matter much to the central bank. Yet, the British pound has given back all of last week’s gains following the discovery of another case of Foot and Mouth and the release of weaker than expected BRC retail sales today.  The last outbreak in 2001 cost the UK as much as GBP10 billion pounds.  Local groups are already screaming that the ban on livestock exports could cause the meat and livestock industry to lose as much as GBP10 million a day.

Sharp Reversal Candles in Yen Crosses
Strong reversal candles can be seen in all of the Yen crosses, but USD/JPY was the only pair that managed to end the US trading session in positive territory.  The Dow Jones continued to be the primary driver of yen strength or weakness given the lack of Japanese economic data released overnight.  The Bank of Japan did release its monthly economic report however in which it raised its labor market assessment for the first time in two years.  On the economy, the BoJ feels that the outlook has not changed.  Finance Minister Omi and Economic Minister Ota beg to differ.  Omi claims that Japan has beaten deflation while Ota indicated that the economy and labor market are both improving.  Japanese Machine orders are due for release tonight.  A big retracement is expected after last month’s rise. 

Euro Falls Back Into its Ranges
The Euro’s failure to close near its high yesterday was a good leading indicator for today’s weakness.  In contrast to the sharp rise in factory orders, industrial production actually fell short of expectations in the month of June.  It appears that big ticket items boosted orders and those take time to be reflected in production.  Current account and trade figures from Germany are due for release tomorrow.  Although we could see further losses in the Euro, support should come in at 1.3670.  The European Central Bank is still expected to raise interest rates next month and there is no major US or European data left on the economic calendar. As a result, the EUR/USD is most likely expected to revert back into 1.3600-1.3850 trading range.

Written by Kathy Lien, Chief Strategist of DailyFX.com

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