Why the Fed and Treasury delayed the inevitable

Compared to its open price at the onset of US trading, the EUR/USD is
basically unchanged. We actually saw only a mild amount of volatility yesterday
despite two major events on the US calendar. The day has been interesting, but
the price action less so. Broadly speaking the US dollar is weaker on the day,
losing the most ground against the Japanese Yen. If we needed to sum up the
day’s activity in one line, we would say that the US is delaying the inevitable.

The Federal Reserve is still leaving the door open for more rate hikes, but
injected more cautious wording while the US Treasury refrained from naming China
as a currency manipulator but toughened up their criticism by calling for more
rapid progress. Specifically, the Federal Reserve raised interest rates by a
quarter of a point to 5 percent, marking their sixteenth consecutive rate hike.
To the shock of the market, the Fed did not tone down the FOMC statement
significantly. They repeated that “some further policy firming may yet be
needed,” but if you read carefully, you will notice that the word “yet” is new.

The reason why the dollar gave back all of its initial gains is because the
market is divided on what to think feel about this new word. As a sign of
hesitancy some say that it means the Fed will raise rates in June but pause in
May while others say that a June rate hike is unlikely. We think that the
statement still has an air of hawkishness and suggests that even though we are
close to end of the tightening cycle, yesterday’s rate hike will probably not be
the last. Inflation pressures are still hanging over the economy and traders
also tend to forget that a weak dollar also boosts inflation pressures by making
imports more expensive, so the Fed is walking on a very fine tightrope. There
are still two more CPI readings till the June meeting which means that they
opted to postpone the inevitable by giving themselves a chance to first reviews
upcoming economic data.

For the time being, as the Fed has said in their statement, the extent and
timing of further increases will indeed be data dependent. As for the Treasury,
it seems that politics outweighed economics. The positive comments on the
initiatives and promises made by Chinese President Hu and Premier Wen suggest
that the US is trying to play nice and gain political favor with China at this
critical time. In line with our introduction of a third scenario in yesterday’s
column, the US chose the “middle ground” and refrained from branding China as a
currency manipulator but toughened up their criticism. They felt that China was
making “far little progress” on exchange rates and that the Treasury will
“closely monitor” any developments. Should China not deliver any further
changes, they could very well still be named in November, especially if
geopolitical tensions subside by that time. The muted reaction on yesterday’s
reports indicate that the US dollar has become very oversold and there may not
be any buyers left in the market. This suggests that if retail sales comes in
strongly today, we see a deep relief rally in the dollar.

Euro

The Euro hit new 12-month highs yesterday largely due to the market’s
overall bearish dollar sentiment but hawkish comments from the European Central
Bank certainly didn’t hurt. Despite the persistent rise of the Euro, the ECB is
showing no signs of backing off from their intention to raise interest rates
next month. According to ECB Weber, “more rate hikes are needed, at least 25
basis points.” He says this even though he believes that first quarter GDP
growth may have been slightly less than 0.5 percent. The GDP release is due out
today.

Overall, the ECB’s clear determination to continue raising rates comes in
contrast to the market’s confusion with the Fed’s new “yet” word — which should
work to the Euro’s benefit. Meanwhile economic data was mostly positive
yesterday with the trade surplus rising in the month of March. An 18.1 percent
increase in exports along with a 28.3 percent rise in imports helped to bring
the surplus from EUR 13 billion to EUR 14.3 billion. However the current account
came in weaker than expected and the seasonally adjusted trade surplus was also
lower, which neutralizes the report a bit. Over in France, numbers were
decidedly better with stronger growth in both industrial and manufacturing
production.

British Pound

Mixed signals from the Bank of England has given the British pound little
direction. The sterling rallied against the US dollar but sold off against the
Euro. As expected, the BoE did notch higher their inflation forecasts, expecting
inflation to remain above 2 percent throughout the next two years. However, they
also reduced their growth forecasts for 2007 and 2008. Although the two changes
are somewhat conflicting, the Bank of England does believes that the slowdown in
growth will be “not much.” The higher inflation pressures already has the market
talking about expectations for interest rate hikes over the next year. According
to the futures markets, a rate hike could come as early as August with one more
down the road. A reinitiating of their tightening cycle should shift the dynamic
between the pound and other currencies, especially if economic data continues to
improve. The UK trade deficit came in better than expected for the month of
March as it narrowed from -GBP 7.04 billion to -GBP 5.45 billion.

Japanese Yen