By DailyFX – Dollar Reverses after FOMC Signaling that Traders Do Not Believe Fed Will Stay Hawkish for Long

It has… … been some time since weve seen this degree of volatility in
the financial markets following an interest rate decision. As expected,
the Fed left interest rates unchanged at 5.25 percent, but both the US
dollar and the US stock market tanked on the back of the monetary policy
statement. The statement was as hawkish as it could be given current
market conditions. Although the Fed felt that the downside risks to
growth have increased, they still believe a strong labor market and
growing incomes will keep economic growth stable. They also
acknowledged that volatility in the markets have increased and credit
conditions have become tighter, but at this point, the problems are not
severe enough for them to stop worrying about inflation and start
focusing on growth. The rollercoaster price action in the financial
markets suggests that traders are still trying to figure out whether or
not to believe the Federal Reserves attempts to calm the market. The
central bank clearly needs more evidence than the few bankruptcies and
blowups that we have seen thus far to shift their tone. Unfortunately
there is never just one cockroach in the closet. More adjustable rate
mortgages will be repriced over the next 6 months, which means the risk
of defaults will continue to rise. Even if the Fed is right, the age of
easy money is over and everyone will be far more careful about the
degree of risk that they are willing to take. Therefore don't expect
a rebound back to all time highs in the US stock market. Instead, it is
more likely that we see the US dollar slip back towards its record lows
against the Euro. Todays Fed meeting was supposed to set the tone
for trading for the remainder of the week. At this point however, it
seems that the market is more doubtful of the FOMC statement than
anything else. This makes the release of the minutes and any further
Fed speak even more important.

Reserve Bank of Australia Expected to Raise Interest Rates

Now that the FOMC meeting is behind us, the next interest rate decision
is in Australia. The Reserve Bank is widely expected to lift interest
rates from 6.25 percent to 6.50 percent. Consumer price growth in the
second quarter was 2.1 percent, which is within their 2 to 3 percent
inflation target. However the prospect of higher inflation in the
months to come will force the central bank to be proactive with raising
interest rates. Retail sales have been hot and businesses are becoming
more optimistic. The market has already priced in an 80 percent chance
for a rate hike, so like the Fed meeting, the key focus will be on the
RBA comments afterwards. The market is actually not expecting the RBA
to raise interest rates again this year. The Australian dollar has
weakened going into the RBA rate decision due to softer than expected
construction sector PMI data last night. The index dropped into
contractionary territory, signaling that the housing market may have hit
its peak. The Canadian and New Zealand dollars are also weaker despite
a continued rise in New Zealands ANZ commodity price index.

British Pound Slips Ahead of Quarterly Inflation Report

The Bank of England will be delivering its Quarterly Inflation Report
tomorrow. Given market expectations for 6 percent interest rates by the
end of the year, in order to satisfy market expectations, the BoE will
have to be hawkish. Economic data has been mixed. Retail sales were
weaker than expected in the month of June but the labor market
tightened. On a headline level, annualized consumer price growth
slowed, but taking a look at just core prices, inflationary pressures
actually increased. At this point the UK economy could handle a year
end interest rate hike, but the outbreak of Foot and Mouth disease
brings with it new risks. It is at an early juncture which means it may
not matter much to the central bank. Yet, the British pound has given
back all of last weeks gains following the discovery of another case
of Foot and Mouth and the release of weaker than expected BRC retail
sales today. The last outbreak in 2001 cost the UK as much as GBP10
billion pounds. Local groups are already screaming that the ban on
livestock exports could cause the meat and livestock industry to lose as
much as GBP10 million a day.

Sharp Reversal Candles in Yen Crosses

Strong reversal candles can be seen in all of the Yen crosses, but
USD/JPY was the only pair that managed to end the US trading session in
positive territory. The Dow Jones continued to be the primary driver of
yen strength or weakness given the lack of Japanese economic data
released overnight. The Bank of Japan did release its monthly economic
report however in which it raised its labor market assessment for the
first time in two years. On the economy, the BoJ feels that the outlook
has not changed. Finance Minister Omi and Economic Minister Ota beg to
differ. Omi claims that Japan has beaten deflation while Ota indicated
that the economy and labor market are both improving. Japanese Machine
orders are due for release tonight. A big retracement is expected after
last months rise.

Euro Falls Back Into its Ranges

The Euros failure to close near its high yesterday was a good
leading indicator for todays weakness. In contrast to the sharp rise
in factory orders, industrial production actually fell short of
expectations in the month of June. It appears that big ticket items
boosted orders and those take time to be reflected in production.
Current account and trade figures from Germany are due for release
tomorrow. Although we could see further losses in the Euro, support
should come in at 1.3670. The European Central Bank is still expected
to raise interest rates next month and there is no major US or European
data left on the economic calendar. As a result, the EUR/USD is most
likely expected to revert back into 1.3600-1.3850 trading range.

DailyFX Research Team
Forex Capital Markets LLC
32 Old Slip, 10th Floor
New York, NY 10004
Tel (212) 897-7660
Fax (212) 897-7669
E-mail: research@dailyfx.com

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