By DailyFX - US Dollar. The US dollar’s rally over the past month has become extremely overextended and the market is finally beginning to feel...

... it.

After yesterday’s sharp movements in the
commodity and stock markets, today’s theme has been retracements. Oil and gold
prices are both slightly higher, along with the Dow. In the FX markets, the buck
has sold off even though today’s US data is more dollar positive than negative,
purely because buyers are starting to become scarce ahead of critical resistance
levels. Inflation is the Fed’s primary focus, which made today’s report on
consumer prices even more important. Headline prices rose 0.4 percent while core
prices rose 0.3 percent, which was slightly stronger than expected. Although it may
seem like only a mild up tick from the 0.2 percent forecast, the three month
annualized rate of core inflation, the number that Bernanke is keeping an eye on,
hit 3.8 percent, the highest level in over a decade. This strong pace of growth has
sent rate hike expectations to 100 percent, with the market already beginning to
price in a tiny chance for another hike in August. However, a closer look at the
report shows that a large part of the rise was due to the higher cost of owners
equivalent rent. The pickup in mortgage rates has made renting a far more
attractive option than owning. Bond yields has risen as traders price in higher
rates, but at the same time the yield curve has inverted further, indicating that
the market believes the higher interest rates will have a big impact on growth.
Even though the rise in owners equivalent rent is an immediate inflationary concern,
it is also a longer term headache. The higher mortgage rates rise, the more risks
it poses for the housing market. The Fed’s Beige Book is already showing signs of
this impact as many of the districts report slower growth and higher inflation. Yet
the Fed has chosen to focus exclusively on the inflation component at the risk of
growth. This is a dangerous game to play, but with such solidarity behind their
decision to unanimously tell the markets that another quarter point rise will be
coming in June, it is a message that we cannot ignore. Therefore until the next
meeting, even if we do see the dollar give back more of its gains, it will probably
not come close to 1.30 in the EUR/USD as the fear of how far the Fed will go keeps
dollar bears cautious of taking on new positioning. Meanwhile tomorrow we are
expecting the TIC data, also known as the report on net foreign purchases of US
securities. Talk of reserve diversification over the past few months could bring
about a weak number, which would extend the dollar’s losses.

Euro
Traders have finally put an end to the longest string of losses in the EUR/USD since
2003. The combination of retracements in the financial markets as a whole and
stronger Eurozone data helped the Euro hold steady above 1.25. French consumer
prices increased more than expected in the month of May, rising by 0.4 percent to an
annualized pace of 2.1 percent while the EU harmonized rate increased from 2.0
percent to 2.4 percent. Even though consumer price inflation was below the ECB’s 2
percent target in Germany, inflation in France and Italy were above it, suggesting
that inflation pressures will continue to be a topic that the European Central Bank
revisits. Employment numbers for the Eurozone as a whole were also encouraging with
first quarter employment growth rising by a better than expected 0.3 percent.
There was talk that central banks were buying Euros near the 1.25 level and we are
not surprised to hear this because it must appear to be a good value point for
central banks, who will continue to stock up their reserves with Euros.

British Pound
Like the Euro, the British pound has recovered after seven consecutive days of
losses. Employment data released in the morning was mixed with the number of
claimants increasing more than expected, the unemployment rate ticking higher from
5.2 percent to 5.3 percent and earnings including bonuses increasing slightly less
than expected. However even so, the UK labor market remains strong. The employment
growth numbers were the strongest since February of last year with solid workforce
participation numbers. Mergers and acquisition news also continues to help the
pound. The latest news to hit the wires was reports that a group led by Goldman
Sachs won rights to purchase Associated British Ports PLC for GBP2.5 billion. There
continues to be more UK data scheduled for release tomorrow, but as we have seen
today, it should have a limited impact on the currency unless it surprises so much
that it would shift rate hike expectations.

Japanese Yen
There was little news out of Japan last night which explains the reason why both the
Japanese Yen and the Nikkei spent the day recuperating its losses. Shifting away
from the Fukui scandal and onto economics, the market’s focus tonight will be on the
comments from Fukui after the monetary policy meeting as well as the release of the
central bank’s monthly report. It is widely expected that the Governor will
continue to be bullish on the economy, reiterating that it remains on the path of
steady recovery. Their plans to eventually raise interest rates should remain
intact even despite the sharp slide that we have been seeing in the equity market.
A rate hike will not be expected until the fourth quarter of this year, but the
latest slide in the Yen does give the Bank of Japan more flexibility. Raising rates
when USD/JPY was at 110 runs the risk of causing a shock to the export sector.
However raising rates when USD/JPY is at 115-117 could take the pair down to
110-112, which may still be within their comfort zones.


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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