Fed Decision Keeps Dollar Steady, Watch ECB Comments, Curve Pricing in 75bp Hike for UK by Year End

- [B]Fed Rate Decision Leads to Further Dollar Strength[/B]

  •      [B]Euro: Watching for a Change in ECB  Trichet?s Comments[/B]
  •      [B]British Pound Strengthens as Futures  Curve Prices in 75bp of Tightening By Year  End[/B]

Fed Rate Decision Leads to Further Dollar Strength

The Fed left interest rates at 5.25 percent today and kept most of the language in the FOMC statement unchanged. The central bank?s concern for inflation will prolong the life expectancy of carry trades, which means that we could see further strength in USD/JPY. For a comparison of the current statement with the one in March, as well as our full FOMC analysis, see the Federal Reserve Instant Insight on DailyFX.com. The Euro and British pound however face their own central bank meetings tomorrow. This could limit any major weakness ahead of those rate decisions. Interestingly enough, the US dollar, bond yields and the Dow are all up on the day. Speculators are so hot on stocks that the intraday dip was quickly erased. This is another reason why carry trades could stay afloat since the relationship between the Dow and carry trades date back at least 27 years. The Fed?s tough stance on inflation raises the question of whether import and producer prices will surprise to the upside later this week. We think that import prices are likely to remain tame since oil prices are falling and the rise in gasoline prices is mostly a domestic issue. The trade balance and jobless claims are also due for release tomorrow. The weaker dollar should help to boost exports, which will narrow the deficit. This leaves jobless claims as the more uncertain release of the two. Last week?s jobless claims dropped to a surprisingly low level of 305k, alleviating some of the concerns about the labor market. If jobless claims continues to remain low, then the US economy may not be in as much trouble as many traders may think. On the other hand should claims rebound back to mid April levels then the prior number may be nothing more than a fluke which of course, would be dollar bearish.

Euro: Watching for a Change in ECB Trichet?s Comments

The ECB or the European Central Bank is expected to leave interest rates unchanged tomorrow at 3.75 percent. The last time they met to discuss interest rates was in April and at that time, the ECB head failed to use the words “strongly vigilant” in his commentary, opting only to say that they will need to act in a firm and timely manner. The last few times that Trichet used the words “firm and timely manner” without the words “strongly vigilant,” rates were not increased in the following month. We are now in that “following month” which is why no one is expecting the central bank to lift rates tomorrow. Instead, what traders are expecting is the reintroduction of those 2 key words that were missing from last month?s comments. A simple look back at Trichet?s changing language between the last two rate hikes in December and March will shed some light on why these words are so important. Before the most recent rate hike in March, Trichet raised rates in December 2006. At the December meeting, after raising rates, Trichet was optimistic, but intentionally dropped the words “strong vigilance” from the comments that he made in the accompanying press conference. He reconfirmed that he has not used the words “strong vigilance” in any of his comments at the January meeting and rates were left unchanged in both January and February. At the press conference after the February meeting, Trichet reintroduced the words “strong vigilance,” paving the way for the quarter point tightening that we saw in March. This suggests that if Trichet plans on raising rates in June, then he will reintroduce the words “strong vigilance” this Thursday. Anything otherwise would indicate that he wants to delay a rate hike, which the market would take as very Euro bearish. Meanwhile Swiss National Bank member Jordan said today that the central bank is not done with raising interest rates; this has put a bid in the Swiss Franc.

British Pound Strengthens as Futures Curve Prices in 75bp of Tightening By Year End

The Bank of England is expected lift interest rates tomorrow, one upping the ECB who will hold off until June. This explains why the British pound has outperformed the Euro since the beginning of the week. Both consumer confidence and retail sales increased in the month of April, confirming that the economy remains strong enough to whether another interest rate hike. Now a 25bp tightening has already been priced into the market so what traders will be watching for are surprises. There is a minority anticipating a 50bp rate hike tomorrow because the futures curve is pricing in one rate hike this month, one next month and one more before the end of the year, for a total of 75bp of tightening. As a central bank that likes to be quick to respond to economic developments, they could just do 50bp of tightening in one clip and let the economy absorb the move over the next few months. The last time the BoE raised rates by 50bp was in February 1995 so this is a low probability scenario, but nonetheless a plausible one.

Japanese Yen Carry Trades Continue to Hold Near Highs

The prospect of a rate hike by the Bank of England tomorrow, one from the European Central Bank in June and steady rates in the US until the end of the year is keeping carry trades near their highs. Yen crosses are continuing to move in lockstep with the Dow and there is no reason for that to change anytime soon. Leading indicators improved in the month of March, but the coincident indicator deteriorated indicating that optimism about future conditions are improving, but sentiment on current conditions is not. Washington is stepping up its pressure on China by conducting hearings on currency manipulation. Read more about this in our Emerging Market China Focus.

Australian and New Zealand Dollars Retrace Ahead of Unemployment Data

Dollar strength has hit both the Australian and New Zealand dollars today. Australian house prices increased less than expected on a quarterly basis, but more than expected on an annualized basis. The outlook for the economy remains promising, which should the pave the way for a decent unemployment report tonight. New Zealand reported an up tick in food prices, but unlike Australia, their unemployment data is expected to reflect more weakness than strength. The Canadian dollar is slightly stronger ahead of the trade and housing market data tomorrow. Strength is expected in both reports.

By Kathy Lien, Chief Strategist of DailyFX.com