Though the quarter point hike in the Fed funds rate to 5.25 pct was expected, the rate-setting Federal Open Market Committee cautioned about the outlook for growth. In response to the statement, the Fed funds futures now attach a 65 pct of another rate hike in August, down on 80 pct predicted before.

‘Its accompanying statement, perceived as more dovish than expected, led to a decline in the dollar and a rally in equity markets,’ said Ian Stannard, currency strategist at BNP Paribas.

Though Stannard is ‘dollar bearish’, he said there is ‘no reason yet to expect the dollar to fall out of bed’, adding that this Friday’s crucial US labour market report has the potential to help the US currency rebound.

A number of currency watchers also think the dollar’s move lower since the Fed statement last week has been overdone.

‘Although the post-Fed trading environment has been characterised by a significant and dollar negative shift in the relative yield structure, the scale of the FX move still looks excessive,’ said Steve Pearson, currency strategist at HBOS.

Importantly, he said pressure on the dollar has been compounded by a renewed appetite for riskier assets, particularly in emerging markets. This renewed appetite has sucked out significant capital from US markets, he added.

The focus on the Fed over recent days has masked a further ratcheting up in European interest rate forecasts following strong euro zone economic news, particularly in Germany, and hawkish commentary from ECB officials, most notably from Yves Mersch, Luxembourg’s central bank governor.

Yesterday release of the euro zone manufacturing PMI survey further reinforced expectations of more aggressive tightening from the ECB.

The main PMI expanded at its fastest pace in nearly six years during June, rising to a seasonally adjusted 57.7 in June from May’s unrevised 57.0. The rise was slightly higher than anticipated. Analysts polled by AFX News had predicted a more modest increase to 57.5.

The data and the commentary have combined to reinforce expectations that the central bank will itself raise its main cost of borrowing in August by a quarter point to 3.00 pct. The ECB has raised interest rates a quarter point every three months since December. If that profile were sustained, another hike would not be due until September.

Meanwhile, the pound was solid following the news that the manufacturing sector saw output rise at its fastest rate in nearly two years during June.

The purchasing managers’ index of manufacturing activity in the monthly Chartered Institute of Purchasing and Supply survey rose to 55.1 in June from an upwardly revised 53.5 in May — the previous May figure was 53.2. The June figure was the highest since July 2004. June’s PMI surprised the market. Analysts polled by AFX News had predicted a modest decline to 53.0.

‘While the survey is unlikely to have a major impact on the Bank of England’s thinking, it modestly bolsters the case for an interest rate hike before the end of the year,’ said Howard Archer, analyst at Global Insight.

SOURCE: AFP

The forward-looking part of the statement seemed a bit more balanced between growth and inflation than previously. It noted that, “although the moderation in the growth of aggregate demand should help to limit inflation pressures over time, the Committee judges that some inflation risks remain”. We are a little baffled by this more balanced signal in light of the Fed’s hawkish inflation campaign in recent weeks.

While the phrasing was more balanced, the statement kept a door open to further tightening by saying that, “The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information”. Importantly, this sentence explicitly links the near-term path of monetary policy to both inflation and economic growth, adding more balance to the statement.

Even though the current statement offers less guidance that previously, we still foresee a further 25bp rate hike in August, taking the fed funds rate to 5.50%, as we do not envisage any significant easing of inflationary pressures in the next couple of months. Beyond August we expect the pace of tightening to slow, as the pace of economic expansion will moderate in Q2/Q3 and the industrial cycle is set to soften in the summer and autumn. Further, the Fed is likely to be more cautious going forward, as it will be aware of the lagged impacts of the tightening carried out so far. However, as we expect inflationary pressures to keep building during the second half of this year and growth to pick-up again around year-end, we would pencil in a further hike to 5.75% in December or January. We see the fed funds rate eventually reaching 6% by Q2 2007.

SOURCE: Danske Bank