By DailyFX - US Dollar. When Ben Bernanke was nominated to take over Greenspan’s job as Federal Reserve Chairman, the market had hoped that the...

... clear speaking economist would give more transparency and stability to monetary policy.

However, in the months since he has taken the job, the market is probably more confused than ever.

The weak non-farm payrolls report on Friday had many traders and analysts convinced that there would
be a pause in June. However, comments by Bernanke this afternoon in Washington have
everyone once again rethinking the possible scenarios. To the surprise of anyone
listening to the speech, Bernanke was fairly hawkish, focusing primarily on the
buildup of inflation pressures and how they must be “vigilant,” a word the European
Central bank used when they first embarked on their tightening policy. He
downplayed the recent weakness in economic data by saying that we are entering into
a period of transition and that the recent moderation in growth is “anticipated.”
The harsh words by Bernanke bring back the possibility of a June rate hike. In
fact, expectations for a quarter point rise at the end of the month has shot up from
less than 50 percent (48 percent to be exact) before Bernanke started to speak to a
whopping 76 percent. When a central banker is as hawkish as Bernanke and stresses
the need to prevent against the increases in energy and commodity prices being
permanently embedded in core inflation, we must listen. Even though this is simply
delaying the inevitable end to interest rate hikes, it will certain give the dollar
some breathing room. Service sector ISM dropped from 63.0 to 60.1 in May, which was
slightly stronger than expected and still represents solid growth. The prices paid
component jumped from 70.5 to 77.5, validating Bernanke’s fears of inflation
pressures. For the remainder of the week, the US calendar is extremely light with
the ECB monetary policy meeting the biggest event over the next few days.
Bernanke’s comments have injected a bit of dollar bullishness going into the
meeting, but with a lot of European economic data due for release from now until
Thursday, expectations of whether the central bank will move by 25 or 50 basis
points could either exacerbate or alleviate the Fed’s more hawkish stance.

Euro

The Euro has come under selling pressure after Bernanke’s comments this afternoon.
ECB President Trichet, who spoke after Bernanke told the market explicitly that he
would not be commenting on monetary policy given the proximity of their interest
rate announcement. He was pleased that growth was moving towards their target and
said that the Eurozone needed to work on their structural problems. Some Euro
selling was seen after a closely followed newsletter for hedge funds predicted that
the ECB would raise rates by only 25 basis points instead of 50. Even though some
proponents have been calling for a half point hike, a quarter point move is really
the more likely scenario. By raising rates by only a quarter point, the ECB leaves
themselves ammunition for the months ahead. By raising 50bp in one meeting when
global growth is at risk of decelerating could exacerbate the rise in the Euro and
the sell-off in the financial markets, which would have negative repercussion for
the region’s economy. Therefore it may be far more logical for the central bank to
give themselves wiggle room by raising only a quarter point on Thursday and then
remain hawkish, but reiterate that any future rate hikes will continue to be data
dependent.

British Pound

The divergence between what is going on in the Eurozone and the UK is becoming
increasingly apparent. The British pound saw a steep 160 pip slide today in
contrast to the Euro, which only sold off by 75 points. Service sector growth in
the UK slowed from 59.7 to 59.2, which was disappointing, but the retracement was
slightly less than expected. What traders are weighing more this week is what the
ECB is doing versus what the Bank of England is not doing. The ECB is clearly on
the path of higher interest rates while the BoE is still in limbo. The recently
conflicting economic reports make the decision even more difficult which suggests
that the central bank will not be delivering any major changes soon. This
divergence has fueled sharp gains for EUR/GBP and exacerbated losses while limiting
gains for the GBP/USD.

Japanese Yen

The Japanese Yen is weaker against most of the majors today as Bank of Japan’s Muto
confirmed that the central bank is in no rush to raise interest rates. The only
piece of Japanese economic data released last night was capital spending which came
in much stronger than expected. Spending rose 13.9 percent in the first quarter,
which compares to the 7 percent consensus forecast. It is undeniable that the
economy is improving, but so far, it hasn’t been enough to give Japanese officials
the confidence to move on rates. Any potential moves will probably be delayed until
the fourth quarter when the LDP changes leadership. At that time, the economy may
also be on a sounder footing which could be a better backdrop for the inevitable
interest rate hike.


Kindest Regards,

Kathy Lien
Chief Strategist
Forex Capital Markets LLC
32 Old Slip, 10th Floor
New York, NY 10004
Tel (212) 897-7660
Fax (212) 897-7669
E-mail: klien@fxcm.com

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