What Bernanke Could be Hinting About Interest Rates

The sharp drop in oil prices has helped to strengthen the US dollar. Pending home sales dropped more than expected, but it has failed to put a dent in the greenback which continues to follow equities higher. The dollar is becoming a safe haven bet as the Federal Reserve reminds us that they will be the lender of last resort. With stocks falling close to a 2 year low on Monday, Fed President Ben Bernanke attempted to stabilize the stock market and the US dollar by saying that they are thinking about "extending the duration" of their emergency lending facilities to investment banks. Is Bernanke trying to tell us something about interest rates? Perhaps, because to extend the availability of emergency lending facilities means that there could still be liquidity problems in the financial markets. Keeping the lifeline open to banks and raising borrowing costs at the same time would actually be counterproductive, especially if they expect the banks to tap into the lifeline. Bernanke is hinting to us that raising interest rates this year, even by 25bp is not a done deal. Oil prices have fallen to $136 a barrel and if crude continues to drop, the Fed's decision about interest rates will be an easy one. Bernanke and his colleagues are becoming extremely sensitive to market prices which could be very dangerous but for the time being its working. Both the stock market and the US dollar have recovered. However oil prices are really dictating Fed policy at the moment. Hawkish comments from Fed President Lacker suggest that some Fed officials are still nervous about inflationary pressures and stand ready to act if necessary. Fed fund futures are currently pricing in a 45 percent chance that interest rates will be increased in September, down from a 65 percent chance a week ago. As for the October meeting, there is only a 53 percent chance that rates will be increased; the odds for December are about the same. If the duration of the emergency lending facility is actually increased, then a rate hike by the Federal Reserve in 2008 becomes highly unlikely. The G8 Summit comes to an end tomorrow, no comment about currencies are expected to be made.

Euro Headed Lower?

The Euro came under further selling pressure on the combination of broad dollar strength and moderate comments from ECB officials. ECB member Tumpel-Gugerell said this morning that Trichet’s “no bias” is shared by the entire Governing Council. In other words, no one in the monetary policy committee is committed to another rate hike, especially not with oil prices falling as much as they did today. The final figures for first quarter GDP are due for release along with the German trade and current account balances. Given the sharp drop in industrial production and the decline in export orders, the trade surplus may have shrank by more than expected in the month of May. Another negative surprise could send the EUR/USD below 1.56, which would open up the door for a move down to 1.55.

Sellers Not Letting Up on the British Pound

Traders continue to push the British pound lower against the US dollar. Since last Wednesday, the currency pair has fallen close to 300 pips. Despite modest rebound in house prices in May according to DCLG, business confidence continues to suffer. The British Chambers of Commerce reported that business optimism plummeted in the second quarter. The UK trade balance is due for release tomorrow and like the German numbers, we expect them to be pound bearish. Last month, manufacturing PMI fell to the lowest level since 2001. The export orders component of the report also deteriorated, which is why we believe that the UK trade deficit will continue to grow. As the Bank of England’s monetary policy meeting approaches, more people are talking about the possibility of a rate cut this year. Recent data indicates that the UK economy is in serious trouble and a recession could be right around the corner.

Falling Commodity Prices Drag Australian, New Zealand and Canadian Dollars Lower

The Australian, New Zealand and Canadian dollars have been hit by lower commodity prices and a stronger dollar. Oil prices have dropped $9 over the past 2 trading sessions and hopefully this is a top. The only thing that can prevent the global economy from slowing even further would be a reversal in oil prices. If crude fell back to $100 or even $120 a barrel, central banks around the world could forget about raising interest rates and focus on boosting growth. This would help to bring some relief to companies and consumers who have been forced to cut expenses. Australian business confidence dropped to a 7 year low last month, which is the weakest since September 11th. New Zealand business confidence on the other hand held at a 33 year low. We get to learn how consumers in Australia feel tonight with the release of the Westpac consumer confidence report. Meanwhile Canada will be releasing housing starts. We expect falling oil prices to weigh on the Canadian dollar.

Japanese Consumer Confidence Hits 6-Year Lows

Japanese Yen crosses continued down a volatile path, as the Dow experienced a strong rally. The Yen managed to rally against some but not all of the majors. Economic data was soft, with the Eco Watchers Survey plunging to a 6 year low as high food and oil prices took a heavy toll on sentiment. These numbers could be foreshadowing a similar deterioration in consumer spending as the Bankruptcy rate rose for the first time in 3 months. Looking ahead, Machine Order and Machine Tool Orders should help investors attain a better understanding of how poorly the business sector may be doing. With no interest rate change in the near future, more trouble in the Japanese economy may only have a limited impact on the Japanese Yen.

Kathy Lien is the Chief Currency Strategist at FXCM.