Traders shift focus on further rate hikes

US Dollar

After the temporary boost provided the dollar after Tuesday’s move to tighter 4.75 percent overnight lending rates, the currency lost most of its volatility as traders awaited economic data that would back Fed comments either way. A strong market reaction was initiated in the previous New York session after the green Fed chief Ben Bernanke issued slightly more positive rhetoric than his predecessor.

Yesterday however, this commentary has cooled in market participants’ minds and the repetitive and cautionary terms “may”, “potential” and “possible” resonated instead. With the market searching out any indicator that would potentially tip off the Fed to sustained inflation, today’s session will offer a healthy dose of central bank fodder. Scheduled for release are the final tallies of fourth quarter gross domestic product and personal consumption. Though these are just recalculated figures, any significant changes from previously reported levels could be indicative of a greater spill over of inflation from higher commodity prices in the business sector to the consumer arena. The same goes for personal spending figures.

All of this aside however, yesterday’s equity market seems to have already spoken its piece on the interest rate issue. With the NASDAQ composite rallying to a five year high, it seems investors are confident that higher interest rates will not create a serious dent in strong business profits that have drove shares higher for much of the last three years.

Euro

After Tuesday’s plummet immediately after the announcement of higher interest rates in the U.S., the Euro climbed slightly higher on market reconsiderations of the implications behind the Fed’s rate hike. The European Central Bank is likely to engage in some tightening of its own this year given the rapid rate of growth that has been assumed by European economies, namely Germany. Business confidence, which stands at it highest in over 14 years, is now being matched by consumer optimism of the highest level in nearly a year. Already strong exports have full potential of spurring growth on the domestic front, which stands to improve on higher levels of employment and consumer spending.

Today’s release of German unemployment change could serve to strengthen the case for growth at home. If indeed domestic growth comes to match the expansion that has been supported by international demand, the ECB will have no choice but to add to the strengthening trend of higher global interest rates. With ECB President Trichet speaking in Zurich tomorrow, traders will be following producer prices in both France and Italy. The possibility of continued wholesale price inflation spilling over into retail markets could stir the ECB to tighten rates from a level that is already considered relatively low by bank officials.

British Pound

Growth in the United Kingdom’s economy stepped up to its fastest pace in a year in the fourth quarter of 2005. GDP grew at a rate of 0.6% from October to December, ending a sour year on a more positive note. Strong economic data regarding consumer credit, positive housing market related indicators, and a potential increase in money supply suggest that inflationary pressure in the British economy may start to build soon, which thus far has been described as “remarkably benign” by BoE Governor King.

Furthermore, the Confederation of British Industry’s report on the industrial sector points to healthy growth in manufacturing, registering a reading of -16. Although only a moderate improvement over the previous index value of -18, the CBI’s survey garners significant enthusiasm considering British industry fell into a recession in the third quarter. Most important in the BoE’s list of policy-setting criteria, however, will be the trend in consumer spending.

Although the fourth quarter’s drop in the national savings rate was encouraging, retail sales got off to a poor start this year. March’s gain in expenditures was weaker than expected—not what the BoE hoped for in its anticipation of a consumption-led turnaround this year. If the BoE is to hold off on cutting rates, domestic spending levels will have to improve slightly to match the recent performance of British exports.

Japanese Yen

The Japanese yen exhibited some strength on the day after retail sales data fed speculation of higher interest rates in the near term. According to the Ministry of Finance, sales in the month of January rose at a 1 percent annualized clip, better than expectations of a 0.8 percent rise. Comparably, on a monthly basis, the figure declined less than expected slipping 1.5 percent. Earlier consensus figures pitted the decline to reach 2.5 percent for the month.

As a result, with sales higher, it remains confirmed that consumers are returning to stores on higher wage growth and growing confidence in future economic expansion. Coupled with recent consumer price data and business sentiment surveys, the report gives plenty of evidence for central bankers to vote in favor of a clear cut end to deflationary policy. The only obstacle that seems to be in place is unanimous agreement with the headline government. Should that come to pass, market expectations would look to finally be met. Looking forward, there still remains plenty of releases for the week. Next up, traders will be concentrating on industrial production figures in contributing further direction.

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.