5% interest rates ahead? Here’s the real story…

US Dollar

The US dollar gained strength in a relatively
quiet day as the market prepares for today’s heavy dose of global economic data.
Here in the US, we are expecting reports from all facets of the US economy
including inflation, foreign appetite for US securities and the housing sector.
Inflation will remain on the top of everyone’s list of things to watch as
producer prices are expected to grow just as fast as consumer prices, if not
faster. It is hardly a secret that producers have borne the brunt of higher
input prices over the past few months as they watch their margins continue to
get squeezed. Higher inflation seems to be the market’s only focus these days as
the futures market has now fully priced in at least 2 more rate hikes to 4.25%
with a more than 50% likelihood of another rate hike on January 31st to 4.50%.

After last Friday’s sharp surge in consumer
prices, we saw analysts from the leading investment banks step out to tout the
possibility of 5% rates. Although we think that this is a bit far fetched given
the dark clouds hanging over nearly every piece of data we have seen over the
past few weeks, it does confirm that the dollar will continue to benefit from
higher interest rates and hold onto its title as the favorite carry trade
currency to go long in 2005.

With no less than ten Fed speeches this week,
nine of who are voters this year or next, we doubt that the Fed will let the
market forget about how concerned they are for inflation. Therefore the risk for
the dollar this week appears to be on the upside, but we will first have to see
how the results of today’s TIC report of foreign purchases of US securities
fares in the month of August.

So far, foreign inflows are expected to reach
$60B, which is less than the previous month, but just about meets the funding
needs for the same month’s trade deficit. If the dollar is lucky enough, as it
has been over the past few weeks, the market could shrug off a weak report like
it did yesterday and proceed on with its rally. The Empire Statement
manufacturing survey shrank from a downwardly revised 15.6 to 12.1. The dollar
barely budged even though the rise was primarily led by the growth in the prices
paid component. The employment component as well as the outlook component both
softened.

Euro

Over the past few weeks, the ECB has been
spending a lot of time clarifying their stance. As a central bank that
traditionally likes to prepare the market for any significant changes to
monetary policy, the ECB is doing a good job of confirming that interest rates
are appropriate and if they were forced to make a move that it would certainly
be to the upside at the moment. ECB members Trichet, Issing and Weber all
reaffirmed the central bank’s hawkish bias.

The highlight of the week in terms of European
economic data will be today’s ZEW survey. The index of economic sentiment is
expected to rebound as the slump that we saw back in September was primarily
attributed to the uncertainty surrounding the German elections. Consumer prices
in the region are also expected to tick higher, validating the ECB’s call for
more vigilance when it comes to dealing with inflation. The inflation rate is
now solidly above the central bank’s 2% pain threshold so they have no choice
but to stay vigilant.

British Pound

The British pound has taken a nosedive as Andrew
Long, Deputy Governor of the Bank of England bows out of his role to join the
private sector. Long will be replaced by Sir John Gieve, the Permanent Secretary
of the home office. As a well-known hawk, Long is said to have played a big role
in the central bank’s more conservative monetary easing policy and more
aggressive tightening policy. His departure is expected to make the Bank of
England’s monetary policy committee more apt to lower rates going forward. The
inexperience of John Gieve could make him more compelled to follow the leaders
for at least the next few meetings before we can get a sense of what his true
bias may be.

As reported in our Morning Brief, house prices
rose by 0.5% according to the October report, which was the biggest jump in 6
months and the first improvement in 5. However, as has been the recent trend,
the outlook for interest rates dominated this morning’s price action.

Japanese Yen

The Japanese Yen shot higher today with a test of
115 now seeming inevitable especially since we are pennies away from that at
this moment. The minutes from the September 7-8 Bank of Japan monetary policy
meeting indicated that the decision to keep the liquidity target unchanged was
7-2 from 8-1 at the last meeting. The BoJ is gradually moving towards an
eventual departure from their zero interest rate policy, although this will not
be something that we see until next year at the earliest.

Meanwhile at the G20 summit in Beijing, the
Chinese Premier pledged to ECB President Trichet that the Yuan will become more
flexible. Although no timeframe or size of further revaluation was discussed, it
validates the market’s belief that China’s job is far from over. Of course, we
believe that China will look for another politically opportune moment to make
their next move and though it will be a minor step it will be politically
significant.

Kathy Lien

Kathy Lien is the Chief Currency Strategist at
Forex Capital Markets. Kathy is responsible for providing research and analysis
for DailyFX, including technical and fundamental research reports, market
commentaries and trading strategies. A seasoned FX analyst and trader, prior to
joining FXCM, Kathy was an Associate at JPMorgan Chase where she worked in Cross
Markets and Foreign Exchange Trading.

Kathy has vast experience within the interbank market using both technical and fundamental analysis to trade FX spot
and options. She also has experience trading a number of products outside of FX,
including interest rate derivatives, bonds, equities, and futures. She has a
Bachelors degree in Finance from New York University. Kathy has written for
Stocks and Commodities, CBS Market Watch, ActiveTrader, Futures and SFO
Magazine. She is frequently quoted on Bloomberg and Reuters and has taught
seminars across the country. She has also hosted trader chats on EliteTrader,
eSignal, and FXStreet, sharing her expertise in both technical and fundamental
analysis.