Jump in CPI could rally Yen

• March 2, 2006
• Kathy Lien

US Dollar

After Tuesday’s extensive dollar sell-off, the greenback licked its wounds and
recuperated some of its losses.  For the second day in a row, it was the 10am
(EST) numbers that moved the markets and not the earlier 8:30am figures.  The
earlier figures were mixed giving the markets no clear direction.  Personal
spending fell short expectations, increasing by only 0.9 percent last month
while spending in December was also revised lower to 0.7 percent. 

Personal income on the other hand grew by the fastest pace
since September and came in stronger than expected.  The trend of spending more
than we earn has been a nasty habit of US consumers.  For the third consecutive
month, Americans have tapped into their savings to finance their spending.  The
savings rate fell to -0.7 percent in January from -0.4 percent in December and
has not been positive since March 2005.  With the housing market showing signs
of slowing, mortgage applications dipping lower last week and construction
spending growth slowing significantly last month, we wonder how much longer this
behavior can last. The only hope is that the labor market continues to grow
strongly, which would give consumers the confidence to continue spending. 

For inflation watchers, the tick higher in the PCE deflator
may have been encouraging, but a closer look reveals that he acceleration in
core prices remained relatively tame.  Slow inflation growth is further
confirmed by the prices paid component of the ISM report, which dipped from 65.0
to 62.5.  The actual index itself jumped from 54.8 to a more than expected 56.7,
which is the primary reason why the dollar rebounded.  After yesterday’s dismal
Chicago PMI number, market expectations were notched down significantly for the
ISM report.  An in line number would have probably been enough to cause a rally,
which means that market took the better number as cause for celebration.  
However, we remain cautious about celebrating prematurely since many other
numbers released over the past 2 days gives the Federal Reserve reason to
refrain from overshooting interest rates and instead, stop at 5.00 percent.  

Euro

Today is central bank day in Euro-land.  The European Central bank has kept us
waiting 3 months now for another rate hike and after much anticipation the
market has pretty much discounted a quarter point move.  We have talked all week
about the wild card at tomorrow’s meeting which will undoubtedly be the
accompanying comments made by ECB President Trichet.  The market expects him to
continue to signal steady interest rate hikes, possibly on a quarterly basis. 
Therefore if he is far more hawkish, we could see a pop in the Euro.  Some
traders have also been entertaining the notion of a 50bp rate hike instead of a
25bp hike tomorrow, but we think this is highly unlikely.  Given the ECB’s
cautious nature and the region’s dependency on exports, they are not likely to
risk a hard earned recovery. 

Economic data released yesterday morning continues to be very
bullish for the Euro.  Manufacturing activity accelerated in Germany, France and
Italy while unemployment was revised lower to 8.3 percent from 8.4 percent. 
Even though the CPI estimate fell from 2.4 percent to 2.3 percent, it still
remains above the central bank’s upper limit which reinforces expectations for
more rate hikes to come.  

British Pound

After being the biggest over performer Tuesday, we had hoped to see an extension
move that would validate a reversal in the British pound against the US dollar. 
However even though the GBP/USD tried, it could not sustain earlier gains and
actually ended up being the most underperforming currency pair today.  Earlier
this week we had said that the relatively light UK economic calendar means that
the British pound’s valuation against the Euro and Dollar would be left to
developments in the US and Eurozone and that is exactly what we have been seeing
so far. 

Tuesday the broad dollar weakness sent the British pound
soaring and yesterday, the dollar recovery dragged the pair lower.  Once again,
economic data released from the UK was mixed with the manufacturing sector index
falling slightly from 51.8 to 51.7 while mortgage lending increased a more than
expected GBP9.2 billion last month, which is yet another indication of
stabilization in the housing market.  

Japanese Yen

Asia was again the market’s main focus, but this time it was China that stole
the limelight and not Japan.  The country’s State Administration of Foreign
Exchange announced last night that they plan on making the Yuan “convertibility
on the capital account in the near term.”  Translating this to plain English, it
means that they plan on easing some of their controls on money leaving China. 
For some time, China has had restrictions or allowances on the amount of money
that can be sent overseas and now they are taking more steps towards making
inflows and outflows more balanced. 

The Japanese Yen has sold off as this encourages outflows and
relieves some of the upside pressure on the Yuan, but over the long-term, it
should be Yen positive as it is yet another step that China is taking towards
making the Yuan fully convertible.  In the meantime in Japan, the market
continues to talk about the Bank of Japan’s plans to drop quantitative easing
ahead of their monetary policy meeting next week.  In most of comments made by
BoJ officials, it seems that any move they take will be small to ensure that
their overnight lending rate does not jump substantially.  We could see a bit
more volatility in the Yen tonight from the CPI numbers.  A big rise could stir
another Yen rally as it builds a stronger case for the BoJ to end their zero
interest rate.

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.