How Much Higher Can the US Dollar Rise?

So far it has been a very good week for the US dollar, which has seen its biggest two day rise in 3 years. In fact, against every major currency except for the Euro and Swiss franc, the greenback has erased all of last week’s losses. Last night, in an exclusive interview with The Times of London, US President George W Bush joined the chorus of government officials calling for a stronger dollar. With no ambiguity in his words, Bush said “we want the dollar to strengthen.” This followed comments by Ben Bernanke who reminded the markets last night that inflation is the central bank’s top priority. According to the Fed chairman, the FOMC will “strongly resist an erosion of longer-term inflation expectations, as an unanchoring of those expectations would be destabilizing for growth as well as for inflation.” Bernanke even went so far as to say that despite the fact that the unemployment rate jumped from 5 percent to 5.5 percent, the US economy has skirted a major decline. If you recall yesterday afternoon, US Treasury Secretary Paulson also said that he would not rule out any policy tool including currency intervention. This clear and cohesive message reflects the seriousness of the Bush Administration and their strong desire to see the dollar rise (Will the Bush Administration Actually Intervene in the US Dollar?). As a direct result of these recent comments, currency traders have sent the US dollar higher for the second day in a row. Since the beginning of this week, the US dollar has already appreciated 300 pips against the Japanese Yen and close to 400 pips against the Euro. How much higher the US dollar will rise will be largely dependent upon this week’s retail sales report as well as this weekend’s G7/G8 meeting. With the labor market deteriorating, if higher gasoline receipts exceed slower spending on other discretionary goods, retail sales could beat expectations. Over the past 30 years, G7/G8 meetings have marked major turning points for the US dollar. Even though only Finance Ministers will be attending the meeting in Japan, intervention could still happen. The US government already supports a stronger dollar, which means that half of the battle for verbal intervention may have already been won. However, it is the Europeans that need to be convinced. With the ECB on a mission to do all that it takes to lower inflation, they may not be willing to let the Euro weaken.

ECB: In State of Heighted Alert

Although the Euro has plunged close to 400 pips as the currency market turned its focus to the comments made by US officials, traders should not lose sight of hawkish comments that have also been made by the European Central Bank. According to ECB member Liikanen, the central bank is in a state of heightened alert. Along with central bank members Liebscher and Noyer, Liikanen stressed the need to contain inflationary pressures and how the rise in prices is making their jobs increasingly difficult. Unsurprisingly, German wholesale prices increased more than expected last month while industrial production beat expectations in France and Italy. Growth in the Eurozone has been steady, which is part of the reason why the ECB has felt comfortable enough to be exceedingly hawkish. However the simultaneous hawkishness of the ECB and the Federal Reserve is exactly what could keep the EUR/USD range bound for at least the next 24 hours.

British Pound Hit By Dollar Strength

Better than expected UK economic data has failed to help the British pound extend its gains for the fourth day in a row. The RICS house price balance was higher than expected last month, suggesting stabilization in the housing market. Meanwhile retail sales as measured by BRC also rose by the most in 4 months while industrial reproduction rebounded. This should be welcome news for the Bank of England who like the ECB needs to concentrate on containing inflationary pressures. If growth continues to stabilize, a rate hike may even be possible. However before that can even happen, we need to see an improvement in the labor market. Tomorrow, the UK will be releasing its employment report and their trade balance. Given the drop in the employment component of the service and manufacturing PMI report, the pound may not receive support it needs from the employment numbers.

Bank of Canada Leaves Interest Rates Unchanged at 3 Percent

To the surprise of the markets, the Bank of Canada decided to leave interest rates unchanged at 3.00 percent compared to the market’s forecast for a quarter point cut. Although growth contracted by 0.3 percent in the first quarter and consumer confidence fell to a 7 year low, the prospect of higher price pressures has reduced the BoC’s dovishness. According to the central bank, “if current energy levels persist, total CPI inflation will rise above 3 percent later this year.” Therefore the current level of interest rates is “appropriately accommodative.” On growth, the BoC is not too worried as they believe that the economy has moved into excess supply. As a result, they expect growth to pick up this year and accelerate in 2009. The Bank of Canada was the last central bank expected to ease interest rates and now that they too have succumbed to inflationary pressures.

USD/JPY Hits 3-Month High

The US dollar hit a 3 month high against the Japanese Yen as broad dollar strength led the currency pair higher. The other Yen crosses did not fare as well however with the US dollar and the commodity currencies the only ones rising against the Yen while the Euro, Swiss Franc and British pound sold off. Stocks have failed to extend Monday’s gains and its vulnerability is affecting the Yen crosses. Tonight, the final numbers for Q1 GDP, the current account balance, the trade balance and CGPI are due for release – expect some action.

Kathy Lien is the Chief Currency Strategist at FXCM.