What Matters More For the US Dollar: Yield or Growth

- British Pound Tanks after UK Nationalizes Northern Rock
- Light Trading Leads to Euro Consolidation

What Matters More For the US Dollar: Yield or Growth?

US traders were off celebrating Presidents Day, leaving the currency market at a standstill after London traders left the office. In Friday's Daily Fundamentals, we talked about how the dollar could rally over the next few days and it has indeed started the week on firmer footing. There was no news or economic data to drive the move, but inflation is the big focus this week and we expect the rise in food and energy prices to drive the price of consumer goods higher. The main reason why the dollar is putting up a good fight is because the market is trying to figure out what is more important, yield or growth. If the only driver of market fluctuations were interest rates, then the US dollar would have already hit record lows against the Euro because Fed fund futures are pricing a more than 75 percent chance that US interest rates will be cut by another 50bp in March. However the recent price action of the US dollar suggests that interest rates may not be the only thing that traders are thinking about. They are looking beyond the current easing cycle to the eventual recovery, which they believe will come swiftly. At that time, those central banks that have not cut interest rates or is just beginning to will find themselves behind the curve, rushing to deal with weakening economic data at a time when US economic data is showing signs of a recovery. The only problem with this thesis is that 2 percent interest rates or 100bp is about as low as the market expects the Fed will go. If banks are forced to take more write-offs and the US economy deteriorates further, the Federal Reserve may be forced to go below 1.00 percent. At the last G7 meeting, finance ministers expect subprime losses to reach 400 billion, far more than the 100 to 150 billion that banks have already reported. More write-offs and losses suggest that banks could continue to tighten their belts, leading to further layoffs and tighter lending standards. Also, the market is pricing in between 50 to 75bp of easing by the ECB this year. So far, the central bank has hinted that they have no plans to lower interest rates. If the expectation for easing proves to be excessive because the Eurozone economy only weakens slightly and inflationary pressures prevent the ECB from taking interest rates far below its current level of 4 percent, we could still see the Euro attempt to break its all time highs.

British Pound Tanks after UK Nationalizes Northern Rock

The biggest story in the currency market today was Prime Minister Gordon Brown's announcement that the government will be temporarily nationalizing Northern Rock. This decision has received a lot of backlash and triggered a wave of British pound selling because in doing so, the government rejected two private sector bids. Taking such a major business into public ownership will cause a serious blow to the government's credibility and expose them to shareholder lawsuits. The government has pledged to return Northern Rock to the private sector when “market conditions are better” but this will not satisfy shareholders who now believe that Northern Rock will be run with politics rather than economics as the primary concern. Meanwhile the Rightmove House Price Index suggests that we could see stabilization in the UK housing market with prices rising 3.2 percent in the month of February. Expect the British pound to be a big focus this week with the Bank of England minutes and retail sales due for release.

Light Trading Leads to Euro Consolidation

With no US or Eurozone economic data released today, the Euro fell marginally against the US dollar. We continue to hear mixed comments out of the ECB, which confirm the market's belief that the central bank is growing less hawkish. ECB member Liikanen said that Eurozone growth will likely fall below 2 percent this year due to weakening sentiment and the ongoing financial turmoil. There is no Eurozone economic data due for release until Wednesday, when we are expecting German producer prices. The Swiss franc on the other hand is down sharply today after a much weaker than expected retail sales report. Consumer spending increased only 1.2 percent in the month December, which was less than a third of the market's 5.2 percent forecast. Although Swiss retailers have been benefitting from low unemployment and rising wages, higher food and energy costs have crimped spending. We are expecting Swiss producer prices and the trade balance later this week, both of which could be bearish for the Franc.

Australian Dollar Continues to Outperform, New Zealand and Canadian Dollars Trail Behind

The Australian dollar continues to be one of the foreign exchange markets' best performing currencies. There was no major economic data released from any of the three commodity producing countries, but strong economic data and hawkish comments from the Reserve Bank of Australia last week continues to push the Australian dollar higher. The New Zealand dollar has followed suit but the Canadian dollar was unchanged on the day. Australian imports are due for release tonight along with Canadian consumer prices tomorrow. The strength of the Australian dollar should boost imports while the strong rise in industrial prices also suggests that Canadian CPI could surprise to the upside.

Mixed Economic Data Provides Little Support for the Japanese Yen

Japanese economic data was mixed last night which explains the lack of clear price action in the Japanese Yen. The tertiary activity index deteriorated in the month of December, led by a sharp decline in retail activity. Leading economic indicators however improved slightly. The Bank of Japan monthly report echoed the same tone held by BoJ Governor Fukui last week. The report talked about the ongoing slowdown in the US economy and its potential impact on the Japanese economy.


DailyFX

Posted in: Forex