The foreign exchange markets are interpreting Federal Reserve Bank Chairman Ben S. Bernanke's gradual relaxing of his inflation directive and lowering the Fed Governors' gross domestic product (GDP) forecast as a dovish development.
Negative sentiment in the U.S. dollar has been exacerbated by the Fed’s downgrade of its GDP forecast and his assessment for the risk of further slowdown in housing.
Six weeks ago, maintaining the interest rate status quo was a positive for the U.S. currency. But today, a continuation of the status quo is a negative for the U.S. currency, especially when Euro zone and Japanese GDP rates are slated to surpass that of the United States, which is barely 3.0% year over year. Plus, today’s disappointing retail sales figures also augur negatively for the engine of the U.S. economy.
Today’s semiannual testimony
“The U.S. economy seems likely to expand at a moderate pace this year and next, with growth strengthening somewhat as the drag from housing diminishes…"
July 19, 2006 semiannual testimony
“The U.S. economy seems poised to grow in coming quarters at a pace roughly in line with the expansion of its underlying productive capacity.”
February 15, 2006 semiannual testimony
“Nevertheless, the risk exists that, with aggregate demand exhibiting considerable momentum, output could overshoot its sustainable path, leading ultimately--in the absence of countervailing monetary policy action.
The Federal Reserve has reduced its forecast for 2007 GDP growth to 2.50% to 3.00%, down from 3.00% to 3.25% as stated in the July 2006 Congressional testimony, and from 3.00% to 3.50% in the February 2006 testimony. The 2007 estimate for the unemployment rate was lowered to 4.50% to 4.75 %, from the 4.75% to 5.00% forecast made in both of last year’s semi annual testimonies. Meanwhile, the 2007 estimate for inflation, as measured by personal consumption expenditures excluding food and energy, core PCE y/y, was maintained at 2.00% to 2.25%. Nonetheless, Bernanke did say in his speech that “Inflation pressures appear to have abated” and “the ebbing of core inflation has likely been promoted as well by the stability of inflation expectations.”
Bernanke’s downside risks more substantial than upside risks
On the risks of his outlook, Bernanke said the following: “To the downside, the ultimate extent of the housing market correction is difficult to forecast and may prove greater than we anticipate. Similarly, spillover effects from developments in the housing market onto consumer spending and employment in housing-related industries may be more pronounced than expected. To the upside, output may expand more quickly than expected if consumer spending continues to increase at the brisk pace seen in the second half of 2006.”
Not only did Bernanke shed more ink on the economic downside risks than he did on the upside risks, but the downside risks are clearly more realistic than the upside risks. Today’s release of the January retail sales report showed no change on m/m basis following a 1.2% increase in December, which was largely boosted by holiday sales. Sales ex autos edged up 0.3% from an 11-month high of 1.25%.
With the unemployment rate rising edging higher, retail sales retreating to negative or unchanged levels, manufacturing in a recession, as seen through the ISM and Chicago PMI, the risks for the U.S. economy are clearly on the downside and so are those for the U.S. dollar.
We stick with our forecast for an aggregate 50-basis point rate cuts in the Fed funds rate in 2007, with the first easing expected to start as early as May.
The expected weakening in this Thursday's industrial production report and Friday's Philly Fed survey could be ominous for the U.S. currency, as they risk further reopening the probabilities of an H1 rate cut.
FX Parameters
EUR/USD breaks through its six-week long consolidation at 1.3070, now facing resistance at 1.3175-80—the two-month trendline resistance. USD/JPY nears the 120.50 trend support, but we expect continued BoJ dovishness to provide a floor above the 120.00 figure. GBP/USD faces hefty resistance at 1.9650— three-week trendline resistance and 50% retracement of the move from the 1.9914 high.
Ashraf Laidi
Chief FX Analyst
CMC Markets US
140 Broadway, 30th Floor
New York, NY 10005
(212) 644-4220
(212) 644-4222 fax
a.laidi@cmcmarkets.com
