It looks like the European Central Bank was right all this time after all as European inflation accelerated last month. Since June 2007, the ECB has kept interest rates at 4% citing the need to fight inflation and drive it down to an acceptable level of 2.5%. On this news, the Euro surged to an all-time high against the Dollar as traders have accepted the fact that the ECB is not likely to cut interest rates for a long time. The Fed, on the other hand, has no choice but to cut interest rates by at least 25 bp at its next meeting on April 30, as housing starts and housing permits were down considerably in March. This prompted talk that the recession is inevitable despite the financial stimulus provided by the Fed. Combined with Tuesday's PPI report showing inflation, it has become clear that the Fed is treading on dangerous ground, as it may have to battle both an economic slowdown and inflation at the same time.

With the interest rate differential between the U.S. and the Euro Zone economy expected to widen, aggressive longs should be able to buy the Euro with confidence and drive it through the psychological 1.60 barrier.

There has been some talk that a move through 1.60 could attract intervention by the G-7 nations, but based on their statement on April 11, as long as there is not excessive volatility they are likely to leave the Euro alone. Despite expressing concerns about wild fluctuations in exchange rates and a forecast for a widespread global economic slowdown, at no time has the ECB or G-7 named a critical price level for the Euro or the Dollar that would be deemed unacceptable. Until news like this is made public, expect traders to continue to push the trend in the Euro higher.

Spreading Inflation Could Compound Problems in the U.K.

Inflation has now showed up on three major economic fronts: the U.K, the U.S. and the Euro Zone. Earlier in the week, the British producer price index showed a surprising gain above expectations. This prompted traders to pull back on selling the Pound as it signaled the possibility of slowdown in Bank of England rate cuts. On Tuesday, the Royal Institution of Chartered Surveyors' measure of sentiment in the U.K. housing market fell to its lowest level in March since it began tracking the data in 1978. Like the Fed, the Bank of England has to figure out how to provide stimulus to the economy while at the same time dealing with the possibility of an inflationary blip. This could trigger a choppy two-sided trade with a bias to the downside in the short-run.

Stronger Dollar Likely to Keep Pressure on Swiss and Yen

Despite a weaker Dollar worldwide, trading was mixed in the Swiss and Yen markets. With traders focusing more on better-than-expected earnings than on ECB inflation and weak U.S. economic reports, the U.S. stock markets rallied sharply higher on Wednesday. Usually this type of move would have brought buying in the USDCHF and USDJPY; however, on Wednesday all it did was trigger excessive volatility in the USDJPY and a down move in the USDCHF. Clearly, traders do not know whether this rally in the stock market is real yet. This explains the tentativeness in Wednesday's trade.

It looks as if Swiss buyers want to focus on the weak Dollar, while Yen traders have their focus geared toward the U.S. stock markets. Look for the USDCHF to continue to trend lower on Dollar weakness and the USDJPY to trade sideways-to-higher if the stock market continues to rally on good earnings.

Soft U.S. Economy May Prevent Runaway Rally in Canadian Dollar

Strong commodity prices in crude oil and gold helped the Canadian Dollar move sharply higher against the U.S. Dollar. As long as these two commodity markets continue to trend on aggressive fund buying, expect the USDCAD to plummet further. Clearly, the Canadian Dollar is benefiting from the weak Dollar and higher commodity prices, but it is still susceptible to U.S. economic weakness. This market has traded like this the whole year so despite the current weakness in the U.S. Dollar, expect the soft U.S. economy to eventually temper the gains in the Canadian. The Canadian financial markets are now factoring in a 50 basis point cut by the Bank of Canada on April 22.

RBA Could Shift Back to Fighting Inflation with a Rate Hike

Several weeks ago, the Royal Bank of Australia issued a statement, which was interpreted as a signal of the end of aggressive rate hikes. This action put in a top in AUDUSD and the market has since sold off despite several attempts to break through to new highs. Inflationary news in the U.K., U.S. and Euro Zone has brought more credibility to the statement from Central Bank Governor Glenn Stevens. Of his concerns, he cited that inflation is quickening and needs to be contained. Traders are reading this as an impending rate hike, and have now increased the odds of a 25 basis point hike over the near term. This potential widening of the interest rate differential along with the need for a higher-yield attracted strong buying to the Aussie on Wednesday. Higher commodity prices especially in gold also helped rally the AUDUSD. With gold expected to continue to rally and the expectation of a future rate hike, trade the long side of the Aussie.

Long-term forecasters are looking for the NZDUSD to fall because of economic weakness. Traders have been factoring a series of rate cuts to drop the key lending rate to 6% by next year. In the short-term, however, traders flocked to the Kiwi as gold and stock prices surged. As long as gold continues to trend higher and the need for high-yielding assets remains firm, trade the NZDUSD from the long side.

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