Federal Reserve: A Rate Hike in the Third Quarter

With no economic data released today, the US dollar weakened modestly as traders toy with the idea of whether the Federal Reserve will raise interest rates in the third quarter. Fed fund futures are currently pricing in a 92 percent chance of a quarter point rate hike in September. One of the primary arguments against a third quarter rate hike is the election year. The fear is that a rate hike could create unwanted political reverberations which could be legitimate if it wasn't for the fact that the Federal Reserve is suppose to be independent. By law, the Fed's monetary policy decisions do not need to be ratified by the President or Congress. Therefore logistically, the Fed should not be sensitive to the political environment, let alone succumb to political pressure. With President George W. Bush having already served 2 terms as President, not up for reelection, this reduces his inclination to meddle with the decisions made by the Federal Reserve. On top of that, historical data indicates that rates have been increased during election years. Over the past 4 decades, there have been 10 elections not including the upcoming one. In 7 out of the past 10 elections, rates were increased at one point or another during the election year. For example in 2004, when George W Bush was up for reelection, interest rates were 1% in January 2004 and at 2.25% by December. In 1988 during Reagan's first election, interest rates were tightened from 14% to 20%. Based upon the past 40 years worth of data, the Federal Reserve is actually more likely to raise interest rates during an election year than to leave them unchanged. Elections should not factor into the Federal Reserve’s monetary policy decisions and if it does, there may be an even bigger problem at hand, which is the independence of the central bank. The Fed’s job is focus on economics and not politics. Meanwhile the Philadelphia Fed index and leading indicators are due for release tomorrow. The drop in the Empire State manufacturing survey skews the risk of the Philly Fed index to the downside.

Euro Edges Higher, SNB Expected to Leave Interest Rates Unchanged

The Euro edged higher against the US dollar but the gains were limited as both the Eurozone and the US economic calendars were devoid of any market moving data. Construction output was the only number released from the Eurozone and the decline in April was slightly less than the previous month. ECB member Stark continued to talk about inflation risks, which may explain why the Euro has strengthened. The Eurozone economic calendar is relatively barren tomorrow as well, which leaves the market’s focus on Switzerland, who will be releasing their latest trade figures as well as making an interest rate decision. The Swiss National Bank is largely expected to leave interest rates unchanged at a 6 year high of 2.75 percent. However like the rest of the world, inflation has also hit Switzerland and as a result, hawkish comments or even a rate hike could come out of tomorrow’s meeting. As recently as May 22, SNB Vice President Hildebrand said that the fastest pace of price growth in 15 years has put the central bank in an “uncomfortable situation.” The possibility of a rate hike has driven the Swiss franc to the highest level against the Japanese Yen since February 1991.

UK Retail Sales May Not Help the British Pound Breakout of its Range

For the past few weeks the British pound has been trading in a range against both the Euro and US dollar. This is primarily due to the fact that the market hasn’t quite figured out what the Bank of England will do next and when. Earlier this week, the letter written by BoE Governor King to Chancellor Darling was surprisingly dovish and provided little information on how they plan on tackling rising inflationary pressures. The release of the minutes from the most recent monetary policy also did not help. According to the BoE minutes, 8 out of the 9 members voted to keep interest rates unchanged while the one dissenter, who is the perennial dove (David Blanchflower) voted for a rate cut. The monetary policy committee discussed everything under the sun including a rate hike and a rate cut. They haven’t decided what to do with interest rates and as a result, the market doesn’t’ know what to do with the British pound. Retail sales are due for release tomorrow and unfortunately a strong or weak report may not help make up the central bank’s mind. The rise in the BRC retail sales report suggests that consumer spending will be strong.

Australian, New Zealand and Canadian Dollars Extend Gains

The Australian, New Zealand and Canadian dollars extended their gains on the combination of dollar weakness and higher commodity prices. Australia also reported better than expected leading indicators and a 7 percent rise in balance of payments. Leading indicators in Canada were right in line with expectations but tomorrow’s consumer price report could be hot. At the last monetary policy meeting, the Bank of Canada was expected to cut interest rates, but instead, they left rates unchanged which was quite a surprise for market watchers. The BoC cited inflation and because of that, there is good reason to believe that consumer prices have continued to trend higher.

Yen Crosses Unfazed By Drop In the Dow

The Dow Jones Industrial Average fell to the lowest level in 3 months but USDJPY was the only Yen pair to be affected. Interestingly enough, it still held up fairly well while all of the other Japanese Yen crosses edged higher. The Bank of Japan released the minutes from their latest monetary policy meeting last night and according to the minutes, the Japanese are keeping a close eye on inflationary pressures and economic growth. It remains to be seen whether the Bank of Japan will raise interest rates before the end of the year. This evening, the all industry activity index is due for release and the number should shed more light on state of the economy.

Kathy Lien is the Chief Currency Strategist at FXCM.