Foreign Currency Report 03 March 06

Sterling fell to a nearly two-week low against the euro on Thursday after the European Central Bank raised interest rates as widely expected and left the door open for more hikes later this year.

After raising rates to 2.5 percent, ECB President Jean-Claude Trichet said rates were still low in the single currency bloc and cited upside risk to prices.

Even though Trichet tried to hold back from making overly hawkish comments, the market interpreted his optimistic outlook on growth and the central bank's higher revisions to mean that the ECB has full intentions to continue tightening monetary policy.

They expect GDP growth to accelerate to 1.7-2.5 percent this year and for inflation to be between 1.9-2.5 percent. Furthermore, they also believe that inflation faces the risk of growing even more if energy prices remain high.

However, Trichet added that they did not decide on a series of rate hikes and never pre-commits unconditionally. Yet, these comments were pretty much shrugged off once he said that the ECB stands ready to 'do what is necessary' and interest rates are now still 'very stimulative.' With more interest rate hikes ahead, the Euro has staged a strong rally today.

'Trichet kept most of his options open at this meeting. He indicated that the ECB would do whatever was necessary to maintain the credibility of monetary policy, and to anchor inflation expectations,' ING said in a note to clients.

Trichet said interest rates remained stimulative for the world's second largest economic bloc while the ECB also raised its forecast for Euro zone consumer inflation (HICP) in 2006 and 2007 and increased growth projections.

Markets have priced in a another 25 basis point rate hike in June and expect benchmark rates to rise to 3 percent by year-end.

Like the Euro, the British pound staged a strong recovery yesterday. However even though the percentage gain in the British pound paled in comparison to the percentage gain in the Euro, after starting the day deep in the red, the intraday recovery was far more impressive.

The only piece of economic data released from the UK was the construction sector PMI index which increased from 50.7 to 51.9 last month. This was slightly more than expected and continues to confirm the stabilization that is occurring in the housing sector. If you recall, yesterday, mortgage lending figures rose more than expected.

As a service sector based economy, tomorrow's service sector PMI survey will be worth watching to see if we can get continued gains in the GBP/USD. Given the strength of today's recovery, we would be surprised not to see an extension move tomorrow.

The only release out of the US yesterday was jobless claims which came in slightly higher than expected, rising 294k compared to the market's 285k forecast. Today should be a bit more helpful for the US dollar on release of the service sector ISM or the University of Michigan consumer confidence reports. The big story yesterday was really the Canadian dollar, which rallied to a 14 year high against the US dollar. The combination of strong data released this week and rallying oil prices has the market thinking about opportunities in the Loonie once again, especially since Canada is also one of the few central banks looking to continue raising rates consistently this year.