It was a wild week in the Forex markets as two of the largest central bank leaders, Bernanke and Trichet, crossed paths momentarily with their views on interest rates and inflation, with the ECB winning out at the end.
Early in the week, the Euro plunged after Fed Chairman Bernanke said the central bank was attentive to the level of the U.S. Dollar.
Traders immediately read this as a sign that the Fed was through cutting interest rates. The Fed Chairman, who rarely comments on matters regarding the Dollar, also emphasized that the Fed was aware of the effect a weaker Dollar had on rising crude oil prices and inflation. The Chairman also indicated that the Fed was working with the Treasury on this matter. Prior to Bernanke’s comments, Treasury Secretary Henry Paulson went on record backing a stronger Dollar.
On Thursday, the European Central Bank made the decision to leave interest rates unchanged at 4%. This was not actually news as the market had been expecting this announcement. What the market was not prepared for was the excessively hawkish comments from European Central Bank President Jean Claude Trichet.
After the announcement, Trichet came out firing and said an interest rate increase in July was possible. This comment caused immediate short covering as traders were forced to cover new shorts placed earlier in the week. All the gains caused by the Bernanke comments were erased.
Early Friday many EUR/USD traders were evening there positions and licking their wounds ahead of the U.S. unemployment number expecting the market to remain range bound or slightly lower over the near term. Many felt that the Bernanke/Trichet comments negated each other and that the market would trade somewhere between the all-time high at 1.601 and the May low at 1.5283.
Friday's non-farm payroll number came out as expected, but the jump in the unemployment rate from 5% to 5.5% was too much for Dollar bulls to handle despite the many ways the media tried to explain how the government came up with that number.
The government's report showed the U.S. unemployment rate increased the most since 1986, adding to speculation that the economy may not be rebounding as anticipated. The financial markets in Chicago almost immediately lowered the odds of a rate cut in December from 78% to 64%.
This action caused interest rates to drop making the differential widen in 2-year notes versus the equivalent Bund, to a difference not seen in 15 years. Near the close this spread differential was at about 2.25 percent. Clearly, the markets were pricing in a possible rate hike in the Euro Zone while lowering the odds of a rate hike in the U.S.
The Dollar plunged on the news as shorts covered positions in the Euro. Adding to the Euro's bullishness later in the morning were comments from ECB executive board member Lorenzo Bini Smaghi who said in Venice that there is broad consensus that a interest rate increase may be necessary next month.
By the end of the day, the Euro was up near the May 27 top at 1.5818. The momentum that was in the market on Friday is likely to continue next week with a test of the all-time high at 1.6019 possible. If this market does pull back, it is likely to see new buyers between 1.5700 and 1.5550.
USD/JPY Falls as Higher Crude Oil Breaks the Stock Market
The USD/JPY could not follow through after Thursday's bullish break out to the upside. The weakness in the stock market caused many traders, who had borrowed Yen to buy stock, to sell out their positions and pay back the money they had borrowed.
Look for resistance at 106.42 while support comes in at 103.86.
The key fundamental supporting a higher USD/JPY is higher interest rates in the U.S. This is a long-term fundamental, however. The Fed adopting a more hawkish tone is also a factor supporting a higher Dollar versus the Yen. These two factors give the trader confidence in the long side. After Friday's break it is clear, however, that this pair needs the stock market to rally to trigger more aggressive buying. Without a stock market rally to stimulate the carry trade, this market will drift sideways-to-lower.
GBP/USD Holds Major Support
This week, the Bank of England kept rates at 5%. There was downside pressure most of the week as weakness in the housing market and low consumer confidence is making the market trade as if rates will have to be cut later in the year.
With the ECB and the Fed warning of inflation, there is no question that the Bank of England is seeing similar statistics. Like the ECB and the Fed, they must also feel the need to raise interest rates. Raising rates with the intention to curtail inflation would also slow down growth, which is already at severely low levels.
What it all comes down to is the Bank of England is in a bad position. What the market is saying is the BoE has to lower rates to stimulate the economy.
The rally on Friday in the GBP/USD was interest rate related. U.S. rates fell relative to the U.K. rates, which made the Pound a more attractive currency.
There is some talk circulating that the BoE is going to let the economy weaken to a point where it counteracts the effects of inflation. Only at that level, some believe, will the economy begin to stabilize.
Swiss Franc Gains on Dollar as Rates May Not Rise in U.S. by December
The drop in U.S. interest rates and the uncertainty in the economy made the Swiss Franc a more attractive alternative to the Dollar.
Early last week, a report came out of Switzerland indicating the presence of inflation. The immediate reaction was a call for higher interest rates later in the year. While the Swiss central bank is pondering a rate hike later in the year, the financial markets in Chicago were lowering the odds the Fed would raise rates by December. With the interest rate spread widening, the USD/CHF became a less attractive investment.
Technically, the market tried to break out to the upside late in the week, but failed at the down trending angle at 1.0528. Key support was broken at 1.0297 along with a main bottom at 1.0215, indicating more downside pressure could be expected next week with 1.0130 the first target.
USD/CAD Expected to Rally on Weak Canadian Economic News
The USD/CAD continued its strong rally as talk of the BoC lowering interest rates brought buying interest to the market. The Bank of Canada is considering a 25 to 50 basis point reduction at its meeting next week.
Employment growth is down in Canada as well as general economic growth. This was noted last week when a report showed the Canadian economy shrunk in the 4th quarter.
The rally in crude oil had little effect on the USD/CAD indicating that traders are more concerned about the Canadian economy than commodity prices. Growth is slow in Canada and inflation is not feared, giving the BoC room to lower rates.
Australian Dollar is Poised to Make a 25 Year High
Despite just recently telling the world that interest rates were staying unchanged at 7.25 percent as previous rate increases have caused a moderation in demand, the RBA is considering rethinking its stance as 4th quarter GDP doubled unexpectedly.
With rates expected to rise in the near-term, traders are buying the Aussie in anticipation of a rally to the 25-year high at .9655. A break through this level is likely to attract more buying which could push the market to .9783.
NZD/USD Could Move Sharply Lower as Market Anticipates Lower Rates
In an effort to stimulate the economy by promoting growth, the Reserve Bank of New Zealand is expected to lower interest rates. Weakness in the economy is evidenced by lower unemployment and lower housing prices.
Lower borrowing costs are needed to help ease the strain of a potential housing bubble and to help regain consumer confidence. Early last month the government attempted to stimulate the economy with a tax cut program. This action, while bullish for the economy, may take months to circulate through the system.
With Australian rates expected to rise and New Zealand rates expected to be cut, traders have been buying the Aussie and selling the Kiwi. This spread trade has been putting more downside pressure on the New Zealand Dollar. A surge to a new 25-year high in the Australian Dollar could correspond with a subsequent break through the recent low in the NZD/USD at .7536.
The charts indicate that a break down through .7536 is likely with a 50% price at .7427 the next major target. On the upside look for resistance at .7780.
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