High inflation and soaring oil prices are once again dictating the action in currencies after hitting a new all time high of $129.50 per barrel. A tumbling dollar has been the order of the day, shadowing all other activity in FX markets. The higher than expected US PPI figures are also a negative for risk appetite and equities as they serve an obstacle to further Fed easing at a time when employment, manufacturing, housing and construction have been on persistent deterioration. The intensifying losses in Wall Street (Dow -200 pts, S&P -15 pts) are speeding up the yen’s gains on reduced risk appetite. The latest oil rise started yesterday after OPEC’s acting president Khelil indicated the world has enough oil and that the cartel will not have a meeting before its scheduled September meeting. Khelil’s comments countered the effect of Saudi Arabia ’s earlier agreement to the US demands to raise output by 300K barrels per day. The oil rally was intensified by oil magnate Boon Pickens' prediction for $150 oil.

Euro hits a 3-week high at $1.5680 on the dollar’s woes. Germany ’s ZEW current conditions index rose to a stronger than expected 38.6 from April’s 33.2, while the ZEW economic expectations index fell to an unexpectedly weak -41.4 in May from 40.7 in April. The current conditions index is more closely correlated with ECB interest rates than the expectations index. The euro was also boosted by remarks from ZEW Chief Economist Franz who said he expected the ECB to raise interest rates in the near-term.

But the story may be different from Germany upon tomorrow’s release of the more influential IFO survey (4 am EST). Markets consider the IFO survey to be a better indicator of Germany ’s economy because it is the survey of business sentiment rather than investor sentiment, which may be skewed by the equity market. The IFO has a strong track record in triggering notable moves in the euro. Major moves in the index have served as catalysts in triggering the euro past big figures ($1.30, $1.40 and $1.50). After having posted an unexpected string of three consecutive monthly increases between January and March, the IFO’s climate index finally retreated in April to 102.4 from 104.8, the largest point drop since September 2001 -- was instrumental in dragging the currency from its $1.60 high to $1.5650 in a matter of days. With the euro having consolidated mostly between $1.5650 and $1.5350 over the past 4 weeks, the currency requires fresh direction from the Eurozone for the latest signals in sentiment and growth expectations.

What to Make of Euro’s Dollar-Driven Gains? EURUSD firms on a combination of soaring oil prices and the stronger than expected current conditions index of the ZEW survey. We pointed out yesterday the remarks from OPEC’s acting president Khelil indicating the world has enough oil and that the cartel will not call an early meeting prior to its scheduled September meeting. Having breached the $1.5650s, EURUSD faces key resistance at $1.5700.

With oil prices surging incessantly and the Eurozone business indicators sending mixed signs, traders may give the benefit of the doubt to the single currency and potentially lifting it past the $1.5720. But another sharp decline in the IFO will is likely lead to losses past 1.56 and 1.5520s.

Aussie Extends to 24-Year High

The Aussie hit fresh 24-yr high against the USD, breaking above 96 cents following a hawkish minutes from release from the Reserve Bank of Australia's interest rate decision earlier this month. The minutes raised the risk of a near-term interest rate hike as they showed the policy board actively considering rates from 7.25% to fresh 12-year highs in order to combat accelerating inflation. Although the minutes did acknowledge substantial slowing in financial market conditions, the market still expects a rate hike to be the next policy change by the inflation-targeting central bank. The challenging part about predicting RBA rate decisions based on inflation is that CPI is released on a quarterly basis rather than monthly, which involves substantial time for price pressures to rebound on the back of rising commodities despite a slowdown in the real economy. We expect the RBA to raise rates to 7.50% before the end of the current quarter.

The Aussie has also been boosted by the recent rebound in gold, which emerged on the heels of soaring oil prices and fresh dollar weakness. We have persistently called for our preference for the Aussie to be one of the year’s strongest FX performers, and called long AUDGBP as our preferred trade of 2008. The pair is now above 9%.

Technically, the chart below shows the Aussie to have broken above a key trend line resistance prevailing since November, and is now ripe to call up 98 cent as the next key target. The chart also shows the pair is inside a larger upward channel, whose upper bound lies just above the 1.00 level. That means, barring any sharp reductions in global risk appetite (AUD negative) and macroweakness in Australia , traders have all the reasons to probe the parity level. Support climbs to 0.9570, backed by 0.9530. On the longer term, key foundation is firmly cemented at 0.9270.

Sterling Upside Still Untenable

Sterling pushes up to a 2-week high of $1.9724 on a combination of general USD weakness and overall strengthening in the EUR and AUD. The current gains are a reflection of oil-driven dollar weakness than improved fundamentals in the UK , thus paving fertile ground for sterling bears to function in this week on the Bank of England minutes (Wed), retail sales (Thur), CBI survey (Thur) and Q1 GDP (Fri). UK data have shown a remarkable consistency of undershooting forecast, leading to rapid and broad selling in the currency. The chart below shows a possible extension of the gains to reach $1.9755 before renewed selling prevails en route $1.95. Whether $1.9750s emerges first remains questionable, but the eventual path is more likely to end below $1.9550 and en route to 1.9500.

Yen Rallies on Whitney and Dollar Woes

Comments from Oppenheimer’s high profile banking analyst Meredith Whitney shedding further pessimism on the banking sector into 2009 are further assaulting risk appetite to the benefit of the Japanese currency. The higher than expected US PPI figures are also a negative for risk appetite and equities as they serve as an obstacle to further Fed easing at a time when employment, manufacturing, housing and construction have been on persistent deterioration.
Anticipating a sharply negative open in Asia, we expect yen gains to reaccelerate and rag USDJPY towards 103.40, followed by 103.00. We expect 102.70 to emerge by end of week. Upside capped at 104.50.