Dollar Steadies as no Fireworks Expected from Fed

By: Ashraf Laidi | Thu, Jun 29, 2006
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3:55 am GER June Unemployment Rate (exp11.0%, prev 11.0%) GER June Change in Unemployment (exp -30K, prev -93K) 4:00 am E-12 May M3 Money Supply Growth y/y (exp 8.8%, prev 8.8%) 8:30 am US Q1 GDP - Final (exp 5.6%, prev 5.3%) 8:30 am US Weekly Jobless Claims (exp 305K, prev 308K) 8:30 am CAN April Real GDP (exp 0.1%, prev 0.1%) 12:40 pm CAN Bank of Canada Sr Deputy Gov Jenkins Speaks. 2:15 pm US FOMC Interest Rate Announcement (exp 5.25%, prev 5.00%).

We expect the Fed to stick to its modus operandi in terms of action and rhetoric, raising the Fed funds rates by 25 bps to 5.25% and keeping the door open for further tightening ahead, as conditioned by its dependence on the incoming data.

Aside from the magnitude of the rate hike, the 3 factors at the top of the list of traders' radar screen in today's FOMC statement will be:

  1. Rhetorical balance between the positives of economic growth and signs of slowdown (2nd paragraph of statement)

  2. Extent of inflation assessment. Will energy prices impact continue to be described as "modest" and will inflationary pressures still be referred to as "potential"? (3rd paragraph of statement)

  3. Phrase indicating possibility of "further policy firming" (4th paragraph)
    In addition to maintaining inflation vigilance and allowing possibility for "further policy firming", the Fed is likely to be more cognizant of the slowing economy. The insistence on further data watch should be of no surprise.

    Nevertheless, recurring inflationary expectations, coupled with the bounce in oil above $71 per barrel should maintain the FOMC's inflation vigilance and keep the phrase indicating: "some further policy firming may be needed".

    Today's much anticipated FOMC decision will prove more anticlimactic than was previously thought a month ago due to the following reasons:

    1. The widely hawkish minutes of the May 10 FOMC meeting (released on May 31), Bernanke's June 5th speech describing 3-month and 6-month inflation as "unwelcome developments" and the consistently hawkish speeches by each Fed official last month sealed the deal for a June rate hike.

    2. Any doubts that the tightening cycle would end this summer due to evident signs of an economic slowdown have been dispelled by a set of data releases that did not convey sufficient urgency to shadow the Fed's immediate battle on inflation.

    The absence of a scheduled FOMC meeting in July will be replaced by the release of today's FOMC meeting (due tentatively on July 18/19) and the Fed's semi-annual testimony to Congress (tentatively on week of July 17), both of which should serve as the much needed anchor for steering market expectations.

    Should the aforementioned forecast prove correct, we expect the dollar to sustain brief losses as a knee-jerk reaction to the less aggressive rate hike, rather than 50 bps as some players may have feared or expected. Although a 50 bps tightening is expected by a negligible minority in the market, the justification of such a policy decision is not unwarranted. But we expect expectations for further tightening ahead combined with the return to data-dependence mode may retain the upward bias in the US currency.

Yen pressured as calls for Fukui's resignation escalate

Continued public demands for Bank of Japan Gov Hayami to resign following his investment in the scandal-ridden Murakami fund have escalated to a new level. This time, senior LDP official Kozo Yamamoto said governor Fukui should quit immediately in an open letter of "personal opinion". This is the first direct call for Fukui's resignation by a lawmaker from PM Koizumi's ruling party. Koizumi, has repeatedly voiced support for the embattled Fukui, who has been credited with instilling stability in Japanese financial markets and the economy after his appointment in early 2003.

Market consensus is now shifting towards a possible Fukui resignation once the central bank implements the much anticipated lifting of its zero interest rate policy, most likely to take place in mid July. Despite Fukui repeated apologies for the scandal and his plan to return 30% of his monthly salary for the next 6 months, 67% of those polled by the Asahi Shimbun newspaper said Fukui should resign for his controversial investment.

The affair is eclipsing increased speculation of BoJ rate hike in 2 week's time, perhaps to the benefit of the Japanese politicians who prefer a relatively weaker currency. Interestingly, any remarks about the economy, monetary policy or currency by Gov Fukui may lose their effect as long as calls for Fukui's resignation remain in the spotlight.

Lingering negative sentiment surrounding Fukui and expectations of further Fed hikes are pushing the dollar towards the key resistance of116.67 yen -- the 61.8% retracement of the 1213.6-108.97 move. We do not rule out breach to extend the pair into the subsequent target of 117.20 -- trend line resistance extending from the 121.36 December high. Interim support stands at 115.80 , followed by subsequent foundation at 115.50--the 100 day MA. Key support stands at 115.20

Euro downside risk ahead

Highlighting the EURSD's tepid reaction to the unexpected rise in German IFO survey reflects shaky sentiment in the single currency against the dollar in light of the FOMC decision. With the Fed firmly expected to raise rates by at least 25 bps in the next 2 months and the US data showing no urgent signs of any disconcerting slowdown, traders are allowing the possibility for a faster increase in the US-EUR yield differential. While there is talk of an ECB rate hike in August, there's no such speculation for July. But the release of the minutes of today's meeting and Bernanke's semi annual Congressional testimony both due in mid July should steer expectations towards further tightening.

Downside risk on EURUSD remains shaped by the prospect of a hawkish FOMC statement that will leave the door open for an August rate hike. Thus, we could see the pair testing the 1.24 figure next month, but more stability should be expected as we approach the August 8 meeting. We do not expect the Fed to deliver an inter-meeting rate hike in July, for the sole reason that such a surprise would trigger a fresh wave of selling in capital markets. Although there's chatter of an ECB rate hike in August 31, the July 6 meeting is deemed too early for pricing a move.

We see interim support tested at 1.2515-20, followed by 1.2470-75 in the event of tough Fed inflation talk. Only escalating hawkishness from ECB would prevent EURUSD from testing 1.2450 in next two weeks. Upside continues to face pressure at 1.2600, followed by 1.2630s.



Ashraf Laidi

Author: Ashraf Laidi

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