The Dip In Inflation Should Be Temporary

By Kathy Lien | March 18, 2010 | 2:22 PM | 0 Comments

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As we have seen from the price action in the forex markets today, what is good for U.S. equities is not necessarily good for the U.S. dollar. The Dow Jones Industrial Average climbed to a 17 year high intraday while the S&P 500 climbed to an 18th month high. Yet the dollar either remained unchanged or weakened against every major currency except for the euro. Currencies and equities behaved very differently because of the nature of the catalyst. The steeper than expected fall in producer prices help to explain why the Federal Reserve decided to keep rates at extremely low levels for an "extended period" of time. Low interest rates are good for stocks because it limits the cost of borrowing but it is bad for the dollar because it reduces the attractiveness of the greenback from a yield perspective. With that in mind however, the market's reaction to the PPI report is still relatively modest.

What to Expect for CPI and Beyond

Although the decline in producer prices suggests that tomorrow's consumer price report will reinforce the lack of inflation in February, we continue to expect a lackluster reaction in the forex market. Gas prices fell significantly in the first half of last month but have since risen to a 1.5 year high. Producer prices fell 0.6 percent in the month of February due primarily to a big drop in energy costs. Excluding food and energy, producer prices actually rose 0.1 percent. However, with oil prices increasing materially since then, the decline in PPI and in turn, CPI should be temporary. For the Fed, this is a good enough excuse o ease their way out of their easy monetary policy in the most gradual way possible. They want to take it one step at a time by first upgrading their assessment of the economy, ending asset purchases and terminating their liquidity facilities. Then they will probably drop the "extended period," and move to raising interest rates a month or two later. This timing is in line with a prior prediction from Fed President Evans. In his testimony on Capitol Hill today, Bernanke also said that keeping rates "too low for too long" could cause inflation. Aside from the CPI report, which we expect to be mildly negative for the dollar, jobless claims, the current account balance, Philadelphia Fed index and leading indicators are also due for release. The deterioration in the trade balance last quarter and the slightly smaller influx of foreign capital should lead to a softer than expected current account balance. Leading indicators should rise but the Philly Fed survey could drop following the decline in the Empire State Manufacturing report.

EUR/USD: NEW ROADBLOCKS FORM FOR GREEK AID

The euro remains range stricken on the continued uncertainty about the possibility of a Greek aid package. German President Angela Merkel was the latest to weigh in on the subject, saying that governments should not make any "rash decisions" in committing funds to help the debt ridden country. Merkel went further by proposing new rules that would see the expulsion of Euro-zone members who manage to consistently defy the requirements set forth by the Maastricht Treaty. Even though current laws would make such a proposal unlikely, her comments serve as a shot in the arm for those trying to put a package together. In her statement today, Merkel also made an effort to satisfy angered Germans who vehemently oppose any sort of bail-out. Since Germany would have to stand in as the main financial backer of such a plan, it is looking more unlikely that Greece will be receiving help anytime soon. Nevertheless, Merkel finds that the situation is probably the "greatest challenge yet to face the euro." Today's data proved to be another disappointment. Construction Output slowed to the weakest pace in more than a year, led by particular softness coming from Germany. Labor Costs rose at the weakest pace in four years, adding new questions as to the health of the employment market. Tomorrow's event risks come in the form of the Euro-zone's Current Account and Trade Balance.

GBP/USD: EMPLOYMENT GIVES NEW LIFE TO THE POUND

The pound accelerates its winning streak to the best 2-day rally in six months. The gains were precipitated after the release of the employment report, which served as a big victory for the British recovery. The pound has been on very shaky ground since the release of last month's employment numbers, which proved to be a major disappointment to markets. However, in one month's time, the picture has completely reversed. Jobless Claims fell by 32.3K or the largest amount in more than 12 years. To make things better, last month's discouraging gain of 23.5K was revised to the downside to a much more manageable increase. Meanwhile, the unemployment rate eased to 4.9%. This one report changes a lot for the country's outlook, but the number has been consistently volatile meaning that only time will tell if these gains will be sustained. The Bank of England's minutes were also released today and what was most notable in their report was their comment on new inflation risks. The monetary policy committee found that "upside risks increased slightly" and said CPI could remain above target, which is probably one of the most hawkish BoE statements that we heard from the central bank in a very long time. Even though it is easy to see that the BoE is far from convinced, they will most likely refrain from boosting QE on these signs alone.

AUD/USD: RATES COULD STILL RISE

The Australian, Canadian and New Zealand dollars extended their gains against the greenback with the Aussie hitting a 2 month high and the loonie reaching a new one year high. Today's central bank comments helped to fuel further gains in the Aussie. The Reserve Bank of Australia's Guy Debelle said that rates "look likely to rise a bit further." Clearly, with added signs provided by yesterday's reserve bank minutes, interest rates have not yet reached "?normal levels'. Economic data also managed to boost confidence in the Aussie, with the Westpac Leading Index rising 0.2 percent to its highest since August 2008. In Canada, the loonie ran to its highest since July 2008 and continues to make its way towards parity. The Canadian government removed a big roadblock for continued CAD strength with the comments from the Canadian Industry Minister. He contends that the country's exporters are "learning to live with" the higher currency. After similar comments from the Canadian Finance Minister, it's safe to say that we can no longer expect officials to talk down the currency as we have seen in the past. The Canadian dollar is enjoying its long stretch of strength against its U.S. counterpart/competitor/partner since July. With little resistance in sight, we believe that the loonie will soon reach parity with the U.S. dollar. Oil prices continue to rise while economic data continues to surprise to the upside. In the month of January, wholesale prices rose by the largest amount in 3 years, which is significant because retail sales (which is due for release on Friday) tends to have a strong correlation with the wholesale figures. The surprisingly strong economic reports have encouraged traders to downplay the recent concerns from Finance Minister Flaherty who called the recovery fragile. Based upon the latest numbers - it is far from that! The persistent rise in oil prices will also help to support oil producers and increase pressure on the Bank of Canada to continue unwinding their emergency measures. So far, there are little signs of weakness and as long as the economy is not moving 1 step forward and 2 steps back, it won't be long before the Canadian dollar reaches parity with the U.S. dollar once again. At that time, the more interesting question becomes how long USD/CAD will remain at parity. The last time the currency pair hit that level was in late 2007, early 2008. The move below parity only lasted for about 2 weeks before the loonie choked up its gains. Canada will release its International Securities Transactions report tomorrow while New Zealand will deliver its latest consumer confidence numbers.

USD/JPY: BOJ DOUBLES STIMULUS

The big event overnight was the Bank of Japan announcement. The central bank doubled the size of their special lending program to 20 trillion yen, making them effectively the most dovish G7 central bank. Interest rates were left unchanged at 0.1 percent, but that did not stop the Japanese Yen from trading lower against all of the major currencies. Given that the central bank upgraded their economic outlook for the first time in 8 months earlier this week, their move was clearly an attempt to pacify government officials who have been on their backs to use monetary policy to jumpstart inflation. Not all members wanted to bend over backwards for the politicians however - for the first time since last October, Noda and Suda dissented. In a statement released after the monetary policy meeting, the BoJ said "Japan's economy is picking up, mainly due to various policy measures taken at home and abroad, although there is not yet sufficient momentum to support a self-sustaining recovery in domestic private demand." Shirakawa also said ""Showing the BOJ's clear stance against deflation will help ensure an improvement in the economy and prices." The question now is whether the BoJ's act will be effective in bolstering prices. The BoJ has increased the money supply, but this is not the real problem - the main issue is that Japanese consumers are not willing to take money out of their wallets and spend. Although the Japanese Yen did not have a big reaction because the announcement was not much of a surprise, it provides an additional reason why the Japanese Yen could extend its losses against the U.S. dollar.

EUR/USD: Currency in Play for Next 24 Hours

EUR/USD will be the currency pair in play for the next 24 hours. The Eurozone will be announcing its Current Account balance at 5:00 am ET or 9:00 GMT followed by the Trade Balance an hour later. Then, in the US, we can expect the Consumer Price Index and Current Account Balance at 8:30 am ET or 12:30 GMT followed by the Philly Fed and Leading Indicators at 10:00 am ET or 14:00 GMT.

Even though the euro lost track of earlier gains, the pair still remains within the Bollinger band buy zone. However, this does not diminish the fact that the pair is still within a clearly defined contractionary range. Today's losses represent yet another retreat off of the powerful 1.3800 resistance level, which has served to push prices lower on several occasions. Support, on the other hand, seems to be firmly rested on the 10-day moving average at about 1.3670. Nevertheless, once again we can expect that it will take a significant catalyst in tomorrow's numbers to break the recent trend.

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