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A Fed rate hike? Not so fast
The greenback picked itself up off the mat, dusted itself off and rallied back from the brink, aided by a surge in US interest rates. Over the course of this past week, US 10 year yields rose 30 points at their highest, before finishing out up 20 bps just above the key 4.00% level. 2 year yields rose over 30 bps, but finished out similarly up about 20 bps and just above the 2.60% level. The proximate cause for the jump in rates was a widely expected upward revision to 1Q US GDP (from +0.6% to 0.9%) and a stronger than expected April durable goods report. The better data came on the heels of several weeks of heightened anti-inflation rhetoric from Fed officials, which was compounded with additional inflation warnings this week from the Fed’s Stern and Fisher, which coalesced into increased prospects for a Fed rate hike. A rate hike?

Seems to me we’ve been here before. Several weeks ago when speculation first swirled that the Fed would react to higher inflation by raising rates, I suggested that the market was pricing in a US recovery before we even went through the downturn. Let’s not forget that 1Q GDP is backward looking and that durable goods is a notoriously volatile data series. Instead, let’s remember that the US is in the midst of a serious downturn where the greatest pain, from the broad consumer-led sector, has yet to fully materialize. Let’s also remember that nearly every other US data report in recent weeks has pointed to further deterioration in the key weak spots of the consumer economy. House prices continue to fall (faster than expected); employment conditions continue to weaken (continuing claims rose to 3.1 mio); energy prices continue to rise (gasoline pump prices hit $4/gallon) and credit conditions remain tight (mortgage rates rose sharply). True, financial market and credit conditions have stabilized in recent weeks and the smell of fear has lifted somewhat. But a blanket of gloom still hangs over markets, and risk aversion seems to be waiting in the wings for an encore rather than exiting the stage completely. About the best that can be said about the US economic outlook is that the deterioration is not accelerating, yet.

The jump higher in US rates is also suspect due to its timing. The bond sell-off/yield surge came suspiciously close to month-end, when market liquidity tends to evaporate and bad things happen to otherwise good positions. I would note that the bond selling/yields rising came to a rather abrupt end on Thursday afternoon after comments from Nobel laureate and Harvard economist Martin Feldstein, who is also the head of the NBER (National Bureau of Economic Research, the designator of recessions, suggested that virtually all current data are pointing lower and that it would be a mistake for the Fed to hike rates now. Yields fell back down, but managed to hold on to the bulk of recent gains. Still, with the fundamental US outlook as precarious as it is, the risk is for further yield declines, especially at the start of a new month. Traders should be alert to Treasury yields dropping back below 2.60% (2 year) and 4.00% (10 year), as a sign that markets are yet again pricing out premature rate hike expectations.

Short-term outlook for the USD
The rise in US rates is the main story behind the recovery in the USD this past week. As FX traders, we have all been forced to become oil and stock traders in recent months, and now it looks like we need become interest rate traders. As I outlined above, the fundamental basis for US rates to rise is highly dubious and we may be witnessing only a short-term rebound in the USD. I remain of the view that we are operating in a broad range environment (EUR/USD 1.53-58, USD/JPY 100-106) as central banks have moved to the sidelines to monitor incoming economic developments. Within the confines of those ranges, though, EUR/USD has dropped out of the upper third and has the potential to see all the way back to the lower end. The drop through the 1.5620/50 support zone is the immediate resistance area that keeps the focus for the EUR lower. The trigger to a push to the lower end of the range is likely on a sustained break of key daily trendline support off the lows from early February, which is now at 1.5500. That trend line was briefly broken on Friday, but we look set to close comfortably above it, keeping it intact on a daily closing basis. Market flows saw real money types selling EUR and buying USD in earnest for the first time this year and the talk was that few were positioned long USD in any significant way. But I am also mindful that the same institutional types were in buying EUR/USD with abandon just two weeks ago above the 1.5750 level. Such is the nature of ranges. EUR/USD strength above 1.5650 is liable to leave few unscathed, but until then I have to favor selling EUR/USD on strength.

USD/JPY is even more highly linked to US rates and seems poised to go which ever direction Treasury yields move. The linkage to stocks seems in abeyance for the moment, but stocks have also been reasonably stable, so I can’t take stock market developments off the radar just yet. USD/JPY is finishing out the week near recent highs around 105.50/80 and I would tend to favor the range top holding. There is also prominent daily trendline resistance at 106.50/60, which is drawn off the highs dating back to July 2007, and that will be the test of whether the USD is truly breaking higher. Key Ichimoku supports are below at 104.20/30, and a drop below there would confirm that the move higher has ended and target weakness back to 102.30/50 initially.

Rate decisions due from RBA, RBNZ, BOE, and ECB
Next week sees rate announcements from multiple central banks. Expectations are for steady rate decisions across the board, but inflation concerns are keeping interest rate tensions high in play. And of course, economic outlook updates will be keenly parsed for signs of future interest rate moves. Below I outline market expectations for each decision and what markets are likely to focus on.

Australia: On Tuesday afternoon Sydney time (0030ET Tuesday/0430GMT) the RBA is expected to hold rates steady at 7.25%. We look for the RBA to maintain a bias towards higher rates, though we agree with the market view that a rate increase is unlikely to occur at next week’s confab. The potential for further rate increases is limited in our opinion given the slowdown in the consumer sector. However, the risk is that the RBA hammers away at inflation and threatens to raise rates in light of increases in consumer inflation expectations, which would tend to be AUD bullish.

New Zealand: The RBNZ announces on Thursday morning Wellington time/Wednesday 1700ET/2100GMT) and the market expects no change to the current 8.25% rate. The recent weakness in economic data – especially sharp declines in employment and retail sales numbers – if continued could convince the RBNZ to move as early as September, however. The recent tax package roll out has been seen by some market participants as too little too late and many believe it will fail to prevent a recession, leading the RBNZ to cut rates sharply in the second half of the year. RBNZ Gov. Bollard’s statement will be critical to the sense of timing of anticipated rate cuts and the risks are that he surprises by indicating cuts sooner than expected, which would likely be NZD bearish.

UK: The Bank of England will announce a likely steady 5.00% interest rate on Thursday morning at 0700ET/1100GMT. The recent BOE Quarterly Inflation Report forecast sharply higher inflation readings later in 2008 and 2009, effectively ending the BOE’s rate cuts. But the UK economy continues to soften and the outlook is arguably worse without additional interest rate relief, suggesting a potentially bearish GBP reaction whether they cut or not.

Europe: The ECB also announces on Thursday at 0745ET/1145GMT and expectations are for a steady 4.00% rate decision. The ECB has effectively been caught between two forces—slowing growth suggesting rate cuts and higher inflation demanding rate hikes. Financial market stability concerns have been another impediment to rate hikes, but with signs of stabilization in credit markets, the prospect of a 25 bp. rate hike are being put back on the table. ECB Pres. Trichet’s 0830ET/1230GMT press conference will closely watched to see if he alters his language suggesting current rates are sufficient to bring inflation down. Should he alter his language, it seems likely to go in only one direction, namely implying a rate hike in coming months, which would tend to be EUR bullish.