US Dollar Strengthens but CPI Data not Expected to Supportive

• US Dollar Strengthens but CPI Data not Expected to Supportive
• Yen May Not Rally Regardless of BoJ Rate Decision
• British Pound - Further Gains Contingent Upon BoE Minutes

US Dollar- Even though the US dollar is stronger ahead of tomorrow’s consumer price report, this does not mean that the market is looking for a strong inflation number. Instead, the lack of US data this week aside from the CPI number and leading indicators is helping the dollar recover some of its losses from the prior week. The recently reported drop in producer prices suggests that we could see a similar decline in consumer prices, especially as inflation growth slows globally. However before we even get to the US CPI release there are a number of potentially market moving events over the next few hours. This includes a testimony by RBA Governor Stevens, the Bank of Japan interest rate decision (which we elaborate on in the Yen commentary), and the minutes from the most recent Bank of England monetary policy meeting. After the CPI report, we have the release of the minutes from the Federal Reserve’s monetary policy meeting in January. This will most likely prove to be a nonevent since the minutes should contain a similar the message as the one that Bernanke delivered at his semi-testimony on the economy and monetary policy, which is that they have adopted a wait and see approach. Recent weakness in US data and concerns about sub-prime mortgages could force the Federal Reserve to hold back on future rate hikes to make sure that the health of the banking sector is not in jeopardy and to avoid forcing even more mortgage borrowers into default by increasing the rate of adjustable rate mortgages.
Euro – After last Thursday’s power move, the Euro has had a very difficult time extending its rally. Today’s weakness comes on the back of softer producer price figures from Germany and less hawkish comments from European officials. Over the past 2 weeks, we have heard nothing but very hawkish comments from Eurozone officials. Today however that hawkishness appears to be abating on the back of comments from Spanish politician Solbes and EU’s Alumnia. Solbes said this morning that interest rates will not go much higher while Alumnia said that inflation pressures are not excessive. Neither of these people are members of the ECB, but the shift is still worth noting. The sole ECB member who spoke today was Mersch who continued to suggest that the central bank will raise rates in March. Over in Switzerland, the inflation and trade data were a wash as producer prices fell short of expectations while the trade surplus beat expectations.
British Pound – The British pound is stronger today thanks to firm money supply and public finance data. M4 money supply grew by a healthy 13 percent in the month of January while net monthly lending hit a fresh record high. This surprising strength is a testament to the difficulty of handicapping the Bank of England’s monetary policy. Economic data is frequently mixed with a batch of weak data followed by a batch of good. Perhaps this is why the BoE has to be so dynamic and have proven to flip their monetary policies as necessitated by the direction of economy. This is the main reason why tomorrow’s release of the MPC minutes from the monetary policy meeting held earlier this month is so important. After delivering a surprise rate hike in January, recent data still leaves the door open for the central bank to raise rates again this year. Whether the British pound has what it takes to break above today’s high is dependent upon how the members of the committee voted earlier this month. If the decision to leave rates unchanged was unanimous, then the odds for a rate hike in March will be very low. If at least 2 members voted in favor of a rate hike, then market expectations will quickly adjust to reflect the possibility of 5.50 percent rates next month.
Japanese Yen - The main event this week is tonight’s Bank of Japan interest rate decision. The Japanese Yen has sold off ahead of the rate decision suggesting that the market is not expecting the announcement to be Yen bullish. This is reminiscent of the interest rate decision back in July 2006 when the central bank raised interest rates for the first time in six years. There are two dominant scenarios for tonight’s announcement, neither of which is completely yen bullish. The first possibility is that the Bank of Japan leaves interest rates unchanged at 0.25 percent. This scenario is quite probable given the low level of inflation and mild pickup in consumer spending. A rate hike at this time may be premature. Unchanged rates would be seen as a disappointment and the Yen will likely weaken on the back of that. The second possibility is that they actually raise interest rates by a quarter of a point. Given the ultra conservativeness of the Japanese government, even if they do so, in order to limit rapid appreciation in the Japanese Yen, they will probably signal that further rate hikes will continue to be gradual and that they will take a break before raising interest rates again. At 50 basis points, Japan’s interest rate is still the lowest in the developed world, which should keep short yen carry trades in play by limiting yen gains. There are two additional scenarios that are worth mentioning, but the possibilities for either are slim. These include a more aggressive 50bp rate hike from the Bank of Japan or a more compromised 15bp hike. Economic conditions have not improved enough to warrant a 50bp hike and it would cause too much volatility in the Yen. The only time in past 15 years that the BoJ raised rates by anything other than quarter point increments was in February of 2001. It is unlikely that they will opt to do so again. To see how the Yen behaved when the BoJ raised rates in July, see our Special BoJ report .
Commodity Currencies (CAD, AUD, NZD) – The Commodity Currencies were weaker across the board today as gold and oil prices plummet. Canadian data was actually pretty decent with Canadian consumer prices coming out right in line with expectations while leading indicators beat expectations. The Canadian economy is doing well and a sharp pickup in housing starts along with warm weather has helped to fuel gains. Retail sales are scheduled for release tomorrow and a similar strength is expected. The Reserve Bank of Australia’s Governor Stevens is scheduled to testify before Parliament later this evening. Given the inflation downgrades last week and the cautious comments from Treasury’s Costello, we expect Stevens to talk down lingering speculation for a rate hike anytime soon.