Rising inflation offers USD support but the market must tread carefully

US CPI and PPI both came in above expectation and this meant some traders pared

back their rate cut expectations. The market has been looking for the Fed to continue

loosening the economy and the news that price pressure remains high threw doubt on

this prediction. What does this mean? The prospect of lower yields from Fed funds has

been one of the reasons the dollar has remained under pressure of late. In contrast,

equity markets have been buoyed by the rate cuts and we have witnessed large shifts

into carry-trade currencies, namely Aussie and Kiwi, as traders look to take advantage

of the widening interest rate differentials.

Short-term support has come from the rising inflation data but the news is not without

risk. Worldwide inflation is due to linger at the higher levels, especially with recent rises

in food and fuel prices. The Fed had insisted that inflation would begin to fall with the

slowing in growth but if it remains elevated it could spell trouble. In this environment the

economy could enter a period of stagflation – A situation where the Fed are unable to

cut rates for fear of runaway inflation despite the economy needing further loosening.

This is a real risk given the economy’s growth hangs in the balance, and there has

been talk of recessionary conditions. It will be interesting to see if the Fed changes

their loosening bias going forward. However, it is likely that this rally is somewhat short

lived, more so against the euro than the pound.

We may see a similar reaction from sterling this week. Tuesday’s CPI figures are

expected to have risen up to 2.2% and any number above this might temporarily ease

the GBP negative sentiment we have witnessed of late. The market turned bearish

after the early rate cut and has since been trying to accurately price in how many more

cuts to come. Housing data in the UK continues to soften and this has not helped the

pound.

The other big release this week is the minutes from the last Bank of England meeting.

The market will be eager to find out how close the voting was. An almost even split

from the nine members should be a little GBP supportive. The consensus is for 6-3,

while a 7-2, 8-1 or 9-0 will not do sterling any favours.

From the US, PCE price index will give us another look at inflation. This index is the

Fed’s preferred measure and a rise in this could bring about a similar reaction to last

week’s upward surprise.

The BoE Governor, King, and the ECB president, Trichet, will be speaking this week.

**Please note** As from 1 January 2008, the euro (EUR) will replace the national

currencies of Cyprus (CYP) and Malta (MTL) and will become legal tender in both

countries.

The Euro had a fairly mixed week, holding value against most low yielding currencies

however coming under pressure from USD and GBP. The German ZEW index, a

measurement of economic sentiment in Europe’s largest economy, fell to its lowest

level since 1993 at -37.2. The institute behind the research stated that the recent Euro

strength has seen growth falter.

At the FOMC meeting on Tuesday, Ben Bernanke and the Federal Reserve decided to

once again cut rates by 25bp to 4.25%. Some market participants had predicted that

due to recent sharp falls in consumer confidence figures that a 50bp cut may have

been the eventual outcome. The accompanying statement pointed to consumer

spending and business investment slowing and the housing market crisis to continue to

spiral. This prompted a move away from risky assets; carry trades weakened, global

equity markets stumbled and the greenback strengthened alongside typical ‘flight to

safety’ investments.

Risk reversal fears and declines on equity bourses weakened the carry trade and

commodity currencies slightly last week.

Aussie dollar mainly followed other commodity currencies on a fairly see-saw week.

The only data release of note was the employment figures which showed an increase

of 52,600 in November although unemployment figures showed an increase of to 4.5%

from 4.3%. As with all other emerging market currencies, year-end liquidity problems

will affect volatility.

Kiwi was hurt by strong US consumer spending and higher inflation figures losing some

of the gains that been obtained after several central banks announced an action plan to

increase liquidity in the fx markets. The NZ business confidence figure released early

Tuesday morning should prove informative as a barometer of how businesses

domiciled in New Zealand are holding up against the RBNZ’s aggressive monetary

policy.

As predicted, CAD moved further away from parity with the USD on American strength

and industrial commodity price falls. Worthwhile data was hard to come by although

housing starts jumped up slightly. Bank of Canada Governor Dodge expressed relief

that the loonie had weakened back to more acceptable ranges while there were no

clear hints on the timing of any further interest rate cuts.

South Africa released its ‘Quarterly Bulletin’ on Tuesday with GDP figures rising to

4.7% in Q3 up from 4.4% previously. This continues and extends fears that the MPC is

in somewhat of a quandary as on one hand growth slows however on the other inflation

is increasing. This will lead to another rise in rates in January and an uncertain 2008. In

political news, Thabo Mbeki and Jacob Zuma are battling it out for leadership of the

ANC although this has little bearing on financial matters as of yet.

to contact me at anytime regarding these briefings, if you have any questions or thoughts on

them, or if you are interested in a particular event in the calendar.

Please call us on 0800 001 5055 if you have any questions or would like to discuss the markets.

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The above comments are only our views and should not be construed as advice. You should

act using your own information and judgement. Although information has been obtained from

and is based upon multiple sources the author believes to be reliable, we do not guarantee its

accuracy and it may be incomplete or condensed. All opinions and estimates constitute the

authors own judgement as of the date of the briefing and are subject to change without notice.

Any rates given are interbank and therefore for amounts of £5million and so are not indicative of

rates offered by World First for smaller amounts.

RPI +0.4% (+4.2%) +0.3% (+4.2%)

Permits 1.17m s.a.a.r. / -7.2% 1.15m / -1.7%

Current / Expectations 110.4 / 98.3 110.0 / 98.0

Core PCE +0.2% (+1.9%) +0.2%

GBPUSD, move as any combination of two of these rates must produce the third in order to satisfy a

condition known as No Arbitrage. If there are movements in two markets, then the third must move

deterministically. Also knows as triangulation.

higher yield economy (Australia). This yields a certain profit unless the interest rate differential narrows, or

the exchange rate moves such that it costs more to buy the currency back.

Macroeconomic models (such as eCIP).

elements like energy and luxury consumption leaving the ‘boring’ elements like utility bills and food.

[Quotes from BoE governor Mervyn King]

Interest Rate Traction: Although there is a group of people who announce an interest rate, it has to feed

through the economy through some very complex and poorly understood channels. Once rate hikes are

having an effect on inflation and long term yields it is said that they are finding traction with the economy.

who are not employed.

Participation rate: The percentage of the population of working age in the labour force.