Weekly Currency Wrap-up The currency markets have been dominated by interest rate decisions and expectations over the past week.
The US Federal Reserve delivered the expected 0.25% increase in interest rates to 4.50%, the 14th consecutive increase. The FOMC meeting was also the last chaired by Alan Greenspan who has now been replaced by Ben Bernanke. The statement accompanying the interest rate decision continued to refer to inflation risks, primarily due to energy prices and potential capacity constraints, while economic growth was described as uneven. The Fed stated that further rate increases may be needed, but there was no commitment to tightening policy again.
The FOMC was anxious to give as much flexibility as possible to Bernanke and avoid being boxed in by market expectations.
The US data over most of the week was mixed, but did hint at inflation concerns. The key monthly employment report recorded a weaker than expected 193,000 increase in payrolls for January, but previous data was revised stronger and the unemployment rate fell to 4.7%. There was a also a 0.4% increase in earnings which will maintain wage-inflation fears The ISM index for the manufacturing sector fell to 54.8 in January from 55.6 the previous month as the employment index deteriorated. Consumer confidence strengthened to a 3-year high for January, boosted by confidence in the labour market, and construction activity remained strong while there was a slowdown in pending home sales.
US Treasury yields strengthened over the week with 10-year yields close to 4.60% as markets moved to price in a further Fed interest rate increase for March with futures prices attaching at least an 85% probability to another increase. The strengthening of US interest rate expectations helped push the dollar to near 1.20 against the Euro with the US dollar challenging levels below the 1.20 level after the US payroll report.
The Euro-zone data was mixed over the week with main indicators close to or slightly below expectations, but the German PMI indices were significantly stronger than expected, reinforcing market confidence in the German economy.
As expected, the ECB left interest rates unchanged at 2.25%. In the press conference, ECB Chairman Trichet again offered a mixed picture. He warned that growth risks were still on the downside, but he also warned that inflation risks remained elevated. Trichet repeated that the bank would be vigilant over inflation and he described market interest rate expectations, which are pricing in a March increase, as reasonable.
The movement in oil and commodity prices remained an important influence over the week. Oil prices retreated from highs near US$70 p/b, but remained at elevated levels while there were gains for gold prices to a fresh 25-year high. The yen remained vulnerable, undermined in part by yen funds being invested in commodity currencies. There will be further debate over the implications of high commodity prices, especially for gold.
The strength could be seen as an indication of strong growth in the global economy with strong demand for commodities and the need for higher interest rates. It could also be interpreted that markets have lost confidence in central banks’ ability to keep inflation down and that gold is seen as an inflation hedge. This is, however, contradicted by the still relatively low level of bond yields even though yields have increased over the past week.
A third possibility is that the gains are being fuelled by speculative funds and that these will be vulnerable to a reversal as global interest rates rise and liquidity tightens. A fourth possibility is that gains are being driven by Asian central bank reserve diversification as regional banks look for high yields. The factors behind the price strength will have important implications for markets over the next few weeks and months.
The resolution of these potential contradictions will have important medium-term consequences for the major currencies, especially as current trends appear divergent and unsustainable.
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