Yield Curve Inversion Deepens as Market Worries About the Impact of Higher Rates

Published June 15th, 2006 - 01:26 GMT

·  Yield Curve InversionDeepens as Market Worries About the Impact of Higher Rates
·  Stronger Inflation Numbers Boost Euro
·  Optimistic Comments Expected from Bank of Japan Tonight

US Dollar
The US dollars rally over the past month has become extremely overextended and the market is finally beginning to feel it.  After yesterdays sharp movements in the commodity and stock markets, todays theme has been retracements.  Oil and gold prices are both slightly higher, along with the Dow.  In the FX markets, the buck has sold off even though todays US data is more dollar positive than negative, purely because buyers are starting to become scarce ahead of critical resistance levels.   Inflation is the Feds primary focus, which made todays report on consumer prices even more important.  Headline prices rose 0.4 percent while core prices rose 0.3 percent, which was slightly stronger than expected.  Although it may seem like only a mild up tick from the 0.2 percent forecast, the three month annualized rate of core inflation, the number that Bernanke is keeping an eye on, hit 3.8 percent, the highest level in over a decade.  This strong pace of growth has sent rate hike expectations to 100 percent, with the market already beginning to price in a tiny chance for another hike in August.  However, a closer look at the report shows that a large part of the rise was due to the higher cost of owners equivalent rent.  The pickup in mortgage rates has made renting a far more attractive option than owning.  Bond yields has risen as traders price in higher rates, but at the same time the yield curve has inverted further, indicating that the market believes the higher interest rates will have a big impact on growth.  Even though the rise in owners equivalent rent is an immediate inflationary concern, it is also a longer term headache.  The higher mortgage rates rise, the more risks it poses for the housing market.  The Feds Beige Book is already showing signs of this impact as many of the districts report slower growth and higher inflation.  Yet the Fed has chosen to focus exclusively on the inflation component at the risk of growth.  This is a dangerous game to play, but with such solidarity behind their decision to unanimously tell the markets that another quarter point rise will be coming in June, it is a message that we cannot ignore.  Therefore until the next meeting, even if we do see the dollar give back more of its gains, it will probably not come close to 1.30 in the EUR/USD as the fear of how far the Fed will go keeps dollar bears cautious of taking on new positioning.  Meanwhile tomorrow we are expecting the TIC data, also known as the report on net foreign purchases of US securities.  Talk of reserve diversification over the past few months could bring about a weak number, which would extend the dollars losses. 


Traders have finally put an end to the longest string of losses in the EUR/USD since 2003.  The combination of retracements in the financial markets as a whole and stronger Eurozone data helped the Euro hold steady above 1.25.  French consumer prices increased more than expected in the month of May, rising by 0.4 percent to an annualized pace of 2.1 percent while the EU harmonized rate increased from 2.0 percent to 2.4 percent.  Even though consumer price inflation was below the ECBs 2 percent target in Germany, inflation in France and Italy were above it, suggesting that inflation pressures will continue to be a topic that the European Central Bank revisits.  Employment numbers for the Eurozone as a whole were also encouraging with first quarter employment growth rising by a better than expected 0.3 percent.   There was talk that central banks were buying Euros near the 1.25 level and we are not surprised to hear this because it must appear to be a good value point for central banks, who will continue to stock up their reserves with Euros.

British Pound

Like the Euro, the British pound has recovered after seven consecutive days of losses.  Employment data released in the morning was mixed with the number of claimants increasing more than expected, the unemployment rate ticking higher from 5.2 percent to 5.3 percent and earnings including bonuses increasing slightly less than expected.  However even so, the UK labor market remains strong.  The employment growth numbers were the strongest since February of last year with solid workforce participation numbers.  Mergers and acquisition news also continues to help the pound.  The latest news to hit the wires was reports that a group led by Goldman Sachs won rights to purchase

AssociatedBritishPorts PL
C for GBP2.5 billion.  There continues to be more UK data scheduled for release tomorrow, but as we have seen today, it should have a limited impact on the currency unless it surprises so much that it would shift rate hike expectations.

Japanese Yen

There was little news out of Japan last night which explains the reason why both the Japanese Yen and the Nikkei spent the day recuperating its losses.  Shifting away from the Fukui scandal and onto economics, the markets focus tonight will be on the comments from Fukui after the monetary policy meeting as well as the release of the central banks monthly report.  It is widely expected that the Governor will continue to be bullish on the economy, reiterating that it remains on the path of steady recovery.  Their plans to eventually raise interest rates should remain intact even despite the sharp slide that we have been seeing in the equity market.  A rate hike will not be expected until the fourth quarter of this year, but the latest slide in the Yen does give the Bank of Japan more flexibility.  Raising rates when USD/JPY was at 110 runs the risk of causing a shock to the export sector.  However raising rates when USD/JPY is at 115-117 could take the pair down to 110-112, which may still be within their comfort zones. 



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