US Dollar: 96% Chance of a September Rate Hike?

The US dollar has strengthened across the board following a much better than expected retail sales report. Consumer spending increased 1.0 percent in May, the strongest pace of growth in 6 months thanks to tax rebates and higher gasoline prices. Aside from the miscellaneous category, retail sales increased across the board. As the Bush Administration has hoped, Americans are spending rather than saving their tax rebates. This number indicates that the economy most likely skirted negative GDP growth in the second quarter which fueled speculation that the Federal Reserve could raise interest rates before the end of the year. According to the latest Fed fund futures, the market has already priced in a 96 percent chance of at least a quarter point rate hike in September. There is a 67 percent chance that the rate hike could happen in August. These are difficult times for the Federal Reserve who knows that even though recent economic data reinforces their plans to keep interest rates steady, economic growth could easily falter in the coming months. However at the same time, inflation and inflation expectations continue to rise. Although crude oil prices have retraced, they are still hovering near record highs while floods in the Midwest have driven corn prices to all time highs. There is little respite for food and gasoline prices which is why the market believes that despite the risks to growth, the Federal Reserve will have to raise interest rates and not just once. Consumer prices are due for release tomorrow and this will confirm or deny the need for a rate hike. When growth is weak, making inflation a top focus could lead to even weaker economic conditions in the future. Jobless claims jumped to the highest level since March while continuing claims reached their highest in 4 years. More people are losing jobs, raising the risk of a further slowdown in the US economy, but for the time being, the prospect of slower growth is a secondary priority for the Federal Reserve.

Euro Hit by US Data

Stronger Eurozone economic data and hawkish comments from the European Central Bank have failed to prevent the Euro from succumbing to the better than expected US retail sales report. The ECB’s commitment towards fighting inflation is well known, which is why FX traders were not surprised by the release of the ECB monthly bulletin, which confirmed that the central bank is in a state of “heightened alertness.” The warning that they stand ready to act to counter inflation has already been priced into the markets. The possibility of a rate hike by the Federal Reserve on the other hand, is completely new. Eurozone industrial production and French non-farm payrolls were both stronger than expected, reinforcing the ECB’s hawkish bias. Unlike the US, the downturn in the Eurozone economy has been limited, which puts them in much better shape to raise interest rates. Although ECB member Stark suggested that a rate hike would be one-off, if the Federal Reserve can raise interest rates more than once, so can the European Central Bank.

British Pound Nears 3-Months Low

The British pound is closing in on its 3 month low despite the fact that inflation expectations hit the highest level in 15 years. Central Bank governor, Mervyn King attributed the rise in inflation to rising commodity prices. BoE officials are keeping a close watch on the wage rate, for indications of future inflationary pressure. Speculations rise that the BoE would soon be hiking their key interest rate in order to sustain the economy from inflation, however it remain to be seen if Mervyn King would be quick to react, as the economy experiences slowing growth. Due to lack of economic data, investors look forward to next week when consumer prices and retail sales are due for release. In addition, markets will be paying a lot of attention to BoE minutes, in order to attain a clear understanding of central banks sentiment. For the time being, the pound is weak against the dollar and the US CPI report will dictate how the GBP/USD trades over the next 24 hours.

Australian Dollar Plummets, Canadian and New Zealand Dollars Follow Suit

The Australian dollar plummeted following the surprise drop in employment last month. The market was expecting a rise of 13,500 jobs, but instead, 19,700 jobs were lost between April and May. The unemployment rate increased from 4.2 to 4.3 percent, putting an end to 19 months of consecutive job growth. Prior to the employment report, there was widespread belief that the Reserve Bank of Australia would raise interest rates in the coming months and even though this report certainly throws a wrench into those forecasts, the acting Treasurer reminded the market that there is no room for complacency in their “war” against inflation. New Zealand retail sales are due for release this evening. Although they are expected to be rebound due to an improvement in credit card spending, business PMI dipped into contractionary territory last month, so traders should not completely rule out a miss. The Canadian dollar on the other hand has only weakened slightly against the greenback.

USD/JPY Closing in on 4-Month High

The US dollar is closing in on its 4 month high against the Japanese Yen as stronger US economic data drives the currency pair higher. Industrial production and consumer confidence are due for release this evening along with the Bank of Japan interest rate decision. Despite rising inflationary pressures, the Bank of Japan is not expected to raise interest rates until the end of the year, at the earliest. Japan also officially raised meat prices, which is a confirmation that inflation is hitting the country hard.

Kathy Lien is the Chief Currency Strategist at FXCM.