By DailyFX - US Dollar Hit By Rising Risk Aversion Despite Stronger Non-manufacturing ISM.The US dollar struggled to rally despite stronger economic data today. Risk...

... aversion is back in play with the Dow dropping by the biggest amount in over a week.

The ultimate fear in the financial markets is
that this will not just be a one day decline and instead will mark the
end of the rally in US stocks. Although we have said often that the
rally in the Dow is ripe for a turn, nothing has changed in the past 24
hours. Even though the Chinese stock market fell as much as 7.2 percent
last night, it rebounded and ended the day up 2.6 percent. Bernanke
commented on the US economy today, but his message has not changed. He
expects the housing market to remain a drag on the US economy, but he
still expects growth to pick up in the second half of the year and
continued to warn that inflation remains a risk. This is the central
bank governors way of saying, interest rates will remain unchanged
for the remainder of the year. Meanwhile service sector ISM hit a one
year high in the month of May, confirming that the weakness of the US
dollar has not just benefited the manufacturing sector. The underlying
components of the ISM report were also strong with advances seen in
prices paid, employment and new orders. The one thing that has been
weighing on the dollar is reserve diversification. It is confirmed that
Syria will be dropping their dollar peg. They are the second country to
do so in the past 2 weeks. On May 20th, Kuwait switched to a basket of
currencies. Both countries have blamed the weak dollar for boosting
import costs and inflation. There is no significant US data on the
calendar until Friday, but the movements in the Dow and the rate
decisions in Australia, New Zealand, UK and Eurozone will still bring us
market volatility.

Euro Reaction to ECB Rate Decision Will Hinge Upon Trichet
Comments

The Euro held onto its gains today ahead of tomorrows much awaited
ECB interest rate decision. The market has completely priced in a 25bp
rate hike, which suggests that the EUR/USD will probably not budge on
the actual rate announcement. Instead, what will move the Euro are the
comments from ECB President Trichet at the accompanying press
conference. We expect Trichet to remain optimistic about growth but
intentionally drop forgo using the words strong vigilance
regardless of whether he expects to raise interest rates beyond June or
not. This was exactly what he did after the last 2 rate hikes in March
2007 and December 2006 even though the ECB moved on to raise rates again
in the following months. The bigger surprise to the markets will not be
the continually hawkish comments by the central banker but instead more
dovish ones. Recent economic data has been mixed. Even though the
futures curve is pricing in 4.25 percent rates by year end and the
economy could probably handle that, the ECB may want to see how the
region responds to the latest rate hike before instituting another one.
We mentioned yesterday that it is extremely rare for the ECB to raise
rates back to back. Therefore even if rates are to be increased again,
it may not be until September at the earliest. This mornings
economic releases were conflicting. Retail sales in the month of April
fell short of expectations while service sector PMI accelerated. Aside
from the interest rate decision, we also have German factory orders
tomorrow.

British Pound: Bank of England Expected to Leave Rates Unchanged

The British pound continued to strengthen following the stronger than
expected service sector ISM report. Activity in both the manufacturing
and service sector has accelerated, which has helped to boost rate hike
expectations. The prices paid component of both of these reports have
also accelerated. Even though the Bank of England is expected to leave
interest rates unchanged on Thursday, the futures market is now pricing
in another 25bp point rate hike in the third quarter and a slim chance
of 6 percent rates by year end. Two rate hikes is still a stretch at
this point especially with the GBP/USD hovering so close to 2.0. The
longer the currency pair remains at that this level, the more it helps
to reduce inflationary pressures.

Yen Rallies on Dow Weakness

With the Dow down 80 points today, we have seen reversals in all of the
Yen crosses. Most of the pairs are either down for the day or
unchanged. Carry traders are beginning to bail, but they havent
given up quite yet. Bank of Japan Governor Fukui was speaking via
teleconference today. He was slightly optimistic about growth and
repeated his standard view that interest rates remain accommodative and
will be adjusted gradually. The Bank of Japan has little reason to lift
interest rates and this weeks data releases are not market moving.
Therefore traders should continue to take their cue from the US and
Chinese stock markets.

Australian and New Zealand Dollars Rise for Fifth Straight Trading Day

Stronger economic data from Australia has pushed both the Australian
and New Zealand dollars to a 15 year high against the Japanese Yen.
Although the current account deficit was wider than expected, service
sector PMI jumped from 52.8 to 56.1 in the month of May while building
approvals increased by 8.2 percent in April. Taken together with the
stronger company operating profits reported yesterday, there is a decent
chance that GDP growth in the first quarter (which is due for release
this evening) will beat expectations. The Reserve Bank of Australia is
also set to announce an interest rate decision, but rates are not
expected to be changed. This is should be a non-event because the RBA
does not release a statement unless monetary policy is altered. The
Canadian dollar weakened the most in three weeks ahead of IVEY PMI and
building permits. The risk is skewed to the downside for both numbers.
For a more detailed outlook on the Canadian dollar, see our special
report (Canadian Dollar How Much More Can it Rise?). New Zealand has
commodity prices scheduled for release which could be moderately market
moving ahead of tomorrow nights RBNZ rate decision.


DailyFX Research Team
Forex Capital Markets LLC
32 Old Slip, 10th Floor
New York, NY 10004
Tel (212) 897-7660
Fax (212) 897-7669
E-mail: research@dailyfx.com


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