The dollar rose against its rivals Tuesday following Federal Reserve Chairman Ben S. Bernanke's comments. Bernanke said the jump in the May unemployment rate has not materially affected the US economic outlook but the surge in oil prices 'has added to the upside risks to inflation,' increasing speculation the Fed easing cycle is coming to an end as the Fed may be starting to realize that the benefits of a weak dollar and low interest-rate policy are far outweighed by the costs. Canada's dollar gained as the Bank of Canada unexpectedly kept interest rates unchanged at 3.0% due to increased inflation concerns. Sterling declined on new signs of falling UK house prices. The yen fell to the lowest level since February 26.

The AUD/USD tentatively broke the important 0.95-handle support today. This could be an important part of a top in the pair. The AUD/USD has been supported by high Australian economic growth and interest rates. However, Australian economic growth has shown signs of faltering. High commodity prices have also supported the pair. If the Fed focuses more on inflation, that will lower commodity prices and pressure the AUD/USD. We expect a test of the 0.93 support

Financial and Economic News and Comments

US & Canada

• The Federal Reserve is 'aware' that the weak dollar boosts inflation, Dallas Fed President Richard Fisher said in response to questions at the Council on Foreign Relations in New York. Fed Chairman Ben Bernanke said Monday night that the Fed's policy committee 'will strongly resist an erosion of longer-term inflation expectations, as an unanchoring of those expectations would be destabilizing' for the US economy. Inflation is increasingly on the minds of monetary policy makers and rightly so, as the Fed determines inflation.
• There is a strong relation between the US real Fed funds rate and the growth rate of the CRB (Commodity Research Bureau) index, a broad indicator of commodity inflation. The reason is that monetary policy determines inflation, particularly in the commodity market where prices are set on a daily basis and not sticky due to long period contracts. In an open economy like today's integrated world economy, US monetary policy is affecting liquidity not only in the US but also the global liquidity. Excess liquidity is the main determinant of rising commodity prices. Strong demand from booming economies like China, India and others also helps to explain the higher commodity prices but to a lesser extent than generally thought. The notion that rising commodity prices is the result of speculation in the commodity market is outright wrong; speculators and hedgers are only reacting to changed fundamentals, including Fed policies. Politicians' attempt to blame speculators of the rising price problem is just an attempt to show the public that they are doing something, while the main reason for the problem is the Fed's lax monetary policy. The CFTC announced today: 'In light of the recent rise in crude oil and other commodity prices and the influx of new investors into commodity futures markets, the Commodity Futures Trading Commission (CFTC) is announcing the formation of an interagency task force to evaluate developments in commodity markets.'
• The chart below plots the real Fed funds rate (the Fed's main policy tool) versus yearly changes in the CRB price index. The left scale is the real Fed funds rate plotted on an inverse scale; rates above the red 0-line indicate a negative Fed funds rate. The right scale is yearly percentage increases in the CRB index. The correlation between the Fed funds rate and the growth rate in the CRB index is remarkable. It is only during the 2001 recession (gray area) when commodity prices fell despite falling real Fed funds rates. The seed to the inflationary problem was when the Fed kept real interest rates negative from 2002 to 2005, the longest period since the 1970s. Dramatic Fed funds rate cuts during the past months have again led to negative real rates and surging oil prices

• The US trade deficit in goods and services widened to a larger-than-expected $60.9 billion in April from a downwardly revised $56.5 billion in March, the Commerce Department said. Imports rose 4.5% m/m in April, the biggest gain since November 2002, to a record $216.4 billion. Exports rose 3.3% m/m, the most since February 2004, to a record $155.5 billion, led by sales of commercial aircraft, autos and agricultural machinery.

• The Bank of Canada unexpectedly kept its benchmark interest rate unchanged at 3.0% ending a series of rate cuts as higher commodity prices threaten to increase inflation. The BOC said inflation risks have 'shifted slightly to the upside' since policy makers' April forecast and commodity prices have been 'sharply higher than expected.'
• Canada's trade surplus unexpectedly narrowed to C$5.1 billion ($5 billion) in April from a revised C$5.7 billion in March, Statistics Canada reported. Imports increased 2.6% m/m to C$34.8 billion in April and exports rose 0.8% m/m to C$39.9 billion.

Europe

• UK manufacturing production unexpectedly increased 0.1% m/m in April, led by makers of aircraft and cars, following a 0.5% m/m drop in March, the Office for National Statistics said. April UK manufacturing gained 0.1% y/y. The gain indicates the pound's weakness is bolstering demand for UK exports.
• UK industrial production increased 0.2% m/m and 0.2% y/y in April, the Office for National Statistics said.

• UK house prices fell in May as banks approved fewer mortgages. The number of residential property agents and surveyors saying prices fell exceeded those reporting gains by 92.9 percentage points, compared with 94.7% in April, which was the most since the series began in 1978, the Royal Institution of Chartered Surveyors said. The reading for London was -90 in May, close to the 14-year low of -92 in April.
• UK retail sales rose 1.9% y/y in May, the first gain in three months, the British Retail Consortium reported.

Asia-Pacific

• Japan's machine orders rose a less-than-expected 5.5% m/m in April after declining 8.3% m/m in March and 12.3% m/m in February, the Cabinet Office said. Economic and Fiscal Policy Minister Hiroko Ota said demand for machinery is still weak.
  

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