Morning Foreign Exchange Report : Interest Rate Expectations Continue to Subdue the US Dollar

Published: Monday, 21 February 2011 06:55 BST - Written by John Cameron

STORY LINK Morning Foreign Exchange Report : Interest Rate Expectations Continue to Subdue the US Dollar

Violent unrest continues to plague the Middle East, as pro-democracy protestors demand increased freedoms from their leaders. Several protestors were killed by government forces in the Gulf State of Bahrain at the end of last week and hundreds of protestors continue to occupy the Bahraini capital city’s central square. Meanwhile, in Libya, the situation deteriorated over the weekend, with government-paid mercenaries firing live rounds into crowds of civilians, killing hundreds. The son of Libyan ruler, Colonel Gaddafi, has appeared on state television in the last 24 hours, to warn of an impending Civil War in the country.

Ordinarily, such political instability in a key strategic region would cause a flight to safety in the currency markets, with the US Dollar being the major beneficiary. However, the Dollar has continued to trade anaemically against the majors - as of 0545hrs GMT today, it was at 1.3683 against the Euro, some 8c weaker than it was on 10th January of this year. If the violence escalates and spreads to significant oil-producing countries, the Dollar will surely make safe-haven gains along with the Japanese Yen and the Swiss Franc.

Political uncertainty in the Middle East has caused the price of a barrel of crude oil to edge ever closer to its highest level since September 2008, which should provide some support in the markets for oil-driven currencies including the Norwegian Krone and the Canadian Dollar. Crude oil prices are now entering a range where they could begin to subdue the US Dollar, which is a massive net importer of oil.

Last Friday’s Canadian inflation figure came out lower than anticipated at 2.3%, lowering the likelihood of a rate hike in Canada. However, according to market-based yields, the Canadian Central Bank rate is expected to jump by 0.9% in the next year. In comparison, the market expects the US Federal Reserve to raise rates only as high as 0.318% by this time next year, as Bernanke and other FOMC members continue to make dovish comments regarding US inflation.

Meanwhile, in the Eurozone, ECB Executive Board member Lorenzo Smaghi commented on Friday that European policy-makers may be forced to raise interest rates in order to curb inflation. 12-month market yields suggest that the market foresees a likely 88 basis points of European rate hikes in the next year. Smaghi’s comments caused significant support for the Euro throughout Friday‘s session. However caution is still advisable for investors holding Euro-denominated assets as concerns over European sovereign debts persist. The ECB’s emergency lending facility paid out almost €32bn in the final 48 trading hours of last week and Portuguese bond spreads continue to widen to concerning levels.

In the UK, unexpectedly positive retail sales figures for January provided a fillip for the Pound on Friday. Further direction for Sterling will come on Wednesday morning when the Bank of England releases the minutes of its February Monetary Policy Committee meeting. The market is pricing in 84 basis points of interest rate increases for the UK over the next 12 months. If the minutes show that further MPC members joined Sentence and Weale in voting for a hike earlier this month, then the Pound could make significant gains.

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