Yen carry trade returns, while Fed hawks squawk

What happens once the ECB bites the bullet?
The European Central Bank is set to hike interest rates on Thursday – the first of the major central banks to do so. While ECB speakers were fairly thin on the ground this week, the March estimate for CPI all but sealed this week’s rate rise. Prices expanded by 2.6 per cent up from 2.4 per cent in February and prices are now well above the ECB’s target rate of 2 per cent.

This rate hike is all but fully priced in by the forex market, which has kept the single currency supported above 1.4000 in recent weeks even in the face of further peripheral debt turmoil. But future gains for the single currency will depend on what ECB President Trichet has to say after the interest rate announcement on Thursday afternoon.

In March he said that a 25 basis point rate hike in April would not signal the start of a tightening cycle. But one hike will do little to thwart the currency bloc’s inflation pressures, which are mostly driven by commodity prices. A 25 basis point hike would still leave real interest rates in negative territory. Is there a point to only executing a one-off hike especially with the oil price cracking new highs in recent days?

We tend to think not, and Trichet - although he may stop short of signaling the start of a tightening cycle – is likely to be wary of future inflation pressures and leave it open-ended if this rate hike will be followed by others later this year.

This has ramifications for FX markets. The 2-year German-2-year US government bond yield spread has started to narrow since the start of this month as US yields outpace those in Europe . Unless Trichet is on the look-out for future inflation pressures then this yield spread will narrow further, which could weigh on the euro. Look for a break of 1.4240 in EURUSD for further gains towards the 1.4500 August 2010 highs.

There has been some concern about what a rate hike would do to the troubled peripheral economies in the currency bloc. But the ECB will continue to offer liquidity support to Europe ’s troubled banks, and late last week the central bank suspended its minimum credit rating threshold for collateral that banks need to deposit with the ECB to secure access to funds. This is vital, especially for Ireland as its banks’ credit ratings are so low their assets would not be accepted as collateral if the normal rules at the ECB still applied.

So the ECB isn’t abandoning the periphery, but nor is it willing to tolerate above target inflation. This really is policy for a two-tier economy.

RBA likely to remain on hold
On Tuesday April 5, the Reserve Bank of Australia will meet to decide on interest rates. The bank is expected to remain on hold for the fourth consecutive meeting at 4.75% as recent data has showed a moderation in inflation with yearly CPI last released at 2.7% (prior 2.8%). The economic picture down under is strong as indicated by better than expected retail sales for February at 0.5% (cons. 0.4% prior 0.4%) and a faster than expected pick up in private sector credit (0.5% vs. exp. 0.3% prior 0.3%). Despite a February employment change of -10.1K, the economy is nearly at full employment which is seeing upward pressures on wage inflation. We would also note that the -10.1K change in February employment was a result of a larger drop in part time employment (-57.7K) than the rise in full time employment (+47.6K). The addition of full time employment is more significant as the overall numbers may have been distorted by the lingering effects of the floods. The risk is to the upside if the RBA surprises and tightens rates which may see AUD gains extend.

The Australian dollar has seen new post float highs this past week at and is trading at record highs which are around 1.0385 at the time of writing. It is likely that the Aussie will continue to march higher in the week ahead as investors’ increasing appetite for risk leads them to search for yield. Key levels to the upside are likely to be psychological figures of 1.0400 and 1.0500. The RBA may address the elevated levels of AUD as a concern to its export sector which may spark profit taking. Levels of note to the downside are the 1.0300 figure and 1.0200 pivot which were prior highs.

Key data and events to watch in the week ahead
United States: Monday – Fed’s Bernanke speaks on clearinghouses and stability Tuesday – March ISM Non-Manufacturing Composite, March 15th FOMC Meeting Minutes Wednesday – April 1 MBA Mortgage Applications Thursday – Weekly Jobless Claims Friday – Feb. Wholesale Inventories

Eurozone: Monday – EZ Feb. PPI Tuesday – EZ March PMI Composite & services, EZ Feb. Retail Sales, German March. PMI Services Wednesday – EZ 4q F GDP, German Feb. Factory Orders Thursday – ECB Rate Announcement, German Feb. Industrial Production Friday – Finance Ministers & central bankers meet in Budapest, German Feb. Current Account, German Feb. Trade Balance

UK: Monday – March PMI Construction Tuesday – March PMI Services Wednesday – Feb. Industrial Production, Feb. Manufacturing Production Thursday – BOE Rate Announcement Friday – March PPI Output

Japan: Wednesday – Feb. prelim Coincident and Leading Index Thursday – BOJ Target Rate Friday – Feb Current Account Balance, Mar. Eco Watchers Survey

Canada: Wednesday – Mar. Ivey PMI Thursday – Feb. Building Permits Friday – Mar. Employment Report, Housing Starts

Australia & New Zealand: Monday – AU Mar. AiG Performance of Service Index, NZ Mar. ANZ Commodity Price Tuesday – AU Feb. Trade Balance, RBA Interest Rate Announcement, NZ 1Q NZIER Business Survey Wednesday – AU Feb. Home Loans Thursday – Mar. Employment Report

China: Monday – Mar. Non-manufacturing PMI Wednesday – Mar. HSBC Services PMI

Brian Dolan is chief currency strategist at

Disclaimer: The information and opinions in this report are for general information use only and are not intended as an offer or solicitation with respect to the purchase or sale of any currency. All opinions and information contained in this report are subject to change without notice. This report has been prepared without regard to the specific investment objectives, financial situation and needs of any particular recipient. While the information contained herein was obtained from sources believed to be reliable, author does not guarantee its accuracy or completeness, nor does author assume any liability for any direct, indirect or consequential loss that may result from the reliance by any person upon any such information or opinions.

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