Federal Reserve vs. European Central Bank

June 23, 2008

The Federal Reserve begins their two day monetary policy meeting tomorrow and judging from the price action of the US dollar and reports from the press, dollar bulls are treading carefully on the fear that the Federal Reserve will be non-committal.

The continual rise in food and energy prices is adding to the burden on US consumers. The unemployment rate jumped from 5 to 5.5 percent last month, the largest rise in over 10 years. Unfortunately the labor market is expected to worsen as companies like Citigroup and Goldman Sachs announce more layoffs. With this in mind, many people are wondering whether Fed fund futures are overpricing rate hikes.

According to the pricing of the latest contracts, most traders expect 2 rate hikes before the end of the year. If this proves to be overly ambitious, the dollar could come crashing down as the prospect of interest rate hikes is the primary factor driving the dollar higher.

Over the past few weeks, the EUR/USD has been trading in a range as traders try to figure out how who is more hawkish, the Federal Reserve or the European Central Bank.

After surprising the markets with hawkish comments on April 30th, currency traders not only expect the Federal Reserve to pause on Wednesday for the first time since August, but to also raise interest rates before the end of the year.

The ECB on the other hand may only be a one hit wonder this summer.

Although ECB President Trichet warned that interest rates could be increased next month, slowing growth may prevent them from raising rates further than 4.25 percent. Unlike the Federal Reserve, Eurozone interest rates are high because the ECB has not cut interest rates throughout the Fed’s easing cycle. As a result, there isn’t a significant amount of room to raise rates. On top of that, economic data from the Eurozone is taking a turn for the worse. Service and manufacturing PMI both dipped into contractionary territory, taking the composite PMI index for the Eurozone below 50, the lowest on record (Series started in 2005). This explains why there has also been a sharp drop in German business confidence. With the prospect of an interest rate hike, the country is no longer immune to the damaging economic impact of higher oil prices.

If a rate hike is coming, the Federal Reserve would need to toughen up their stance on inflation. The tone of the FOMC statement and more specifically the degree of the Fed’s hawkishness will play a big role in determining where the US dollar is headed next. Dollar bulls will not be happy with anything short of unambiguously hawkish comments from the Federal Reserve. Anything close to a wishy-washy statement will be dollar bearish. With the Federal Reserve meeting right around the corner, the summer doldrums should not be with us for long.