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U.S. Dollar: Countdown to FOMC

Last updated 1/26/2010 5:32 PM ET (GMT -5) 4 Comments

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Kathy Lien

Director of Currency Research, GFT

THE STORIES IN THE CURRENCY MARKET

• U.S. Dollar: Countdown to FOMC
• EUR/USD HIT BY ECB COMMENTARY
• GBP/USD: GDP GROWTH FALLS SHORT OF EXPECTATIONS
• NZD/USD: RBNZ DECISION ON TAP
• AUD/USD: CPI NUMBERS ON TAP
• USD/CAD: OIL AND GOLD PRICES FALL
• USD/JPY: S&P DOWNGRADES OUTLOOK FOR JAPAN

EXPECTATIONS FOR UPCOMING FED MEETINGS

U.S. Dollar: Countdown to FOMC

Based upon the price action in the currency markets over the past 24 hours, it appears that after one day of respite, risk appetite has soured once again. The U.S. dollar traded higher against all of the major currencies except for the Japanese Yen as investors flocked into the safety of the lowest yielding currencies.  Stronger U.S. economic data failed to help the dollar rise against the Yen, the currency pair that most accurately reflects the market’s attitude towards the U.S. economy.  

Counting Down to FOMC

The big event risk tomorrow is the Federal Reserve’s monetary policy announcement.  For the financial markets, the FOMC meeting is one the most potentially market moving events.  Given the recent trend of weaker U.S. economic data, the Federal Reserve is faced with the tough decision of ignoring or acknowledging the acceleration in job losses and the decline in consumer spending.  Having upgraded their assessment of the economy back in December, the Fed may not want to give the impression that they are flip-flopping based upon every piece of incoming data.  Although recent data warrants a more cautious outlook by the Fed, the consequences of downgrading their assessment of the economy far outweigh the consequences of downplaying the latest reports.  If the U.S. central bank suddenly grows more pessimistic, it could exacerbate the slide in equities and trigger further risk aversion in the forex markets because traders will think that in the eyes of the Fed, the deterioration could continue.  If the statement is left unchanged and the tone remains relatively upbeat, the dollar could rally against the Yen but the reaction in the forex markets would probably not be as volatile.  Therefore we believe the Fed will simply signal that the latest deterioration in data is a just a bump in road.  As usual, the 3 things investors we will be looking for tomorrow is the tone of the FOMC statement, changes to the discount rate and any updates to their plans to end emergency programs.  We don’t expect much from the Fed since they already provided details to shut down a large portion of their liquidity programs last month.

U.S. Budget Deficit Could Hit $1.35 Trillion, President Obama to Announce Spending Freeze

Meanwhile the Congressional Budget Office announced that the 2010 budget deficit could hit $1.35 trillion, the highest level since World War II.  This report is released ahead of President Obama’s State of the Union Address on Wednesday night, where he is expected to call for a 3 year freeze on discretionary spending.  The CBO also said the economy will probably grow at a very modest rate over the next few years and if that is true, it would reinforce the Federal Reserve’s plans to keep interest rates at very low levels for an extended period of time.  The deficit is smaller than initially estimated by the CBO but the sheer size of the deficit will weigh on President Obama’s popularity.  The spending cuts are predicted to save approximately $250 billion.  The cutbacks in spending by the U.S. government have both positive and negative implications for the U.S. economy.  On the one hand, it reduces the country’s obligations which could appease foreign investors but in order for the economy to stage a strong recovery, government spending is critical. 

Economic Data Preview and Review

EUR/USD HIT BY ECB COMMENTARY

Despite strong demand for Greek bonds and better than expected economic data, the euro refuses to rise.  Bears are in control with the latest decline the currency pair attributed to risk aversion, dollar strength and comments from ECB officials.  Monetary policy committee member Nowotny said this morning that the current level of the euro is justified by fundamentals and the region’s recovery is dependent upon forex stability.  In other words, if the euro stays at or below current levels, it will help the recovery but if it starts to rise back towards October or November levels, the pace of recovery in the Eurozones could slow.  In the meantime, German business confidence increased for the eighth month in a row, hitting an 18 month high in the process.  Strong demand from Asia has helped to offset the decline in domestic consumption which is interesting because it indicates that Germany has become very sensitive to Chinese growth.  Exposure to China may also be one of the reasons why the euro has been underperforming despite the successful Greek bond auction.  Inflationary pressures are picking up as well with German import prices rising 0.5 percent in December.  Although German consumers have cut back, French consumers have been spending with vengeance particularly during the holiday shopping season which should lend support for Eurozone retail sales.  Meanwhile, the Swiss Franc weakened slightly against the euro following a decline in the UBS Consumption Index.  

GBP/USD: GDP GROWTH FALLS SHORT OF EXPECTATIONS

The British pound fell aggressively following the disappointing fourth quarter GDP report. The market had originally forecasted for GDP to rise by 0.4 percent but instead, it rose by only 0.1 percent, leaving annualized growth at -3.2 percent.  In our daily report yesterday we talked about how we were skeptical about the market’s growth forecasts given the drop in average retail sales and the wider trade deficit in the last three months of the year.  Now we know that growth did not live up to everyone’s lofty expectations.  Nonetheless despite the smaller rise in GDP and the accompanying sell-off in the British pound, the U.K. economy is officially out of recession after six straight quarters of negative growth.  This is only bittersweet considering that Britain was the only G7 country still in recession in the fourth quarter and compared to the rest of the world, growth is still very modest.  For example, when the U.S. economy came out of recession in the third quarter, the economy grew by 2.2 percent.  On a relative growth basis, the U.K. is clearly the underdog and it remains to be seen whether positive GDP growth can be sustained - based upon the data that we have so far received in the month of January, there is a good chance that the recovery will continue.  

NZD/USD: RBNZ DECISION ON TAP

The rally in U.S. dollar and sell-off in commodity prices pushed the Australian, New Zealand and Canadian dollars lower.  No major economic reports were released from the 3 commodity producing countries overnight but the action will heat up over the next 24 hours.   The Asian trading session starts off with the release of Australian consumer prices.  Earlier this week, we learned that producer prices dropped significantly in the fourth quarter and if consumer prices follow suit, the Reserve Bank of Australia could refrain from raising interest rates next month.  Speaking of rate decisions, the Reserve Bank of New Zealand has a monetary policy announcement scheduled at 3:00pm EST / 20:00 GMT on Wednesday.  Although the central bank is not expected to raise interest rates, the recent improvements in economic data could pave the way for a rate hike before the summer.  Back in October, RBNZ Governor Bollard said rates will remain unchanged until the second half of the year but in December he suggested that they could raise rates sooner thanks to a strong housing market.  The RBNZ will most likely reinforce this view by recognizing the improvements in the economy and which may be enough to halt the decline in the New Zealand dollar.  

USD/JPY: S&P DOWNGRADES OUTLOOK FOR JAPAN

Despite the Yen’s rally against the major currencies, the news that Standard & Poor’s downgraded the outlook for Japan’s sovereign debt rating from stable to negative is very bearish for the currency.  Downgrading the outlook is the first step that rating agencies take before actually downgrading the rating. It is a warning to the government as well as investors that Japan needs to reduce its structural deficit or else they will face higher financing costs.  The Yen shrugged off the downgrade as concerns about China triggered a wave of risk aversion across the forex markets. Meanwhile the Bank of Japan left interest rates unchanged last evening and did not alter their outlook for the economy.  USD/JPY is trading below 90, raising concerns about whether the Bank of Japan will verbally or physically intervene in the foreign exchange market.  Based upon the latest comments from Prime Minister Hatoyama, there is “no immediate need to take steps on stock falls or Yen rise.”  For the first time since September, small business confidence has improved which suggests that the recovery is finally spreading to other parts of the economy.  Trade balance figures are due for release this evening and demand from China is expected to boost the trade surplus.  

USD/JPY: Currency in Play for Next 24 Hours

The currency in play for the next 24 hours is USD/JPY. The Japanese trade balance due for release at 00:50GMT or 7:50PM EST. The U.S. will release its new home sales report at 15:00 GMT or 10:00 AM EST followed by the FOMC announcement at 19:15 GMT or 2:15PM EST. USD/JPY is currently trading in the Sell Zone which we determine using Bollinger Bands. After breaching through the critical 90.00 level, which was not only a psychological point but also where the 50 and 100-day SMA sat, the pair is on track to test the 23.6% retracement of last year’s low and high at 88.75.  The downtrend in the currency will remain intact as long as USD/JPY does not break back above the 1st Standard Deviation at 90.50.

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Comments (4)

schultzz.at

January 27, 2010 at 03:35 AM ET

With the effective Fed funds rate at 0.12% and reserves of over 1 trillion I have doubts whether the funds rate is still an appropriate tool. How much assets will they have to sell in Open Market Transactions to raise the rate, say by 0.25%? For sure they do not want to push up Treasury yields and mortgage rates.
Maybe I have misunderstood these operative aspects of monetary policy, but even Richmond Fed president Lacker came up with the idea to adopt the deposit rate as the main policy rate.
Tom Schultz.

alexjbrandt

January 27, 2010 at 04:44 AM ET

Isn't the fund rate how much the Fed reserve pays the banks to put their excess capital into the Fed Reserve? To help limit the growth of inflation/lending. I myself don't have a complete understanding of the Fed Reserve but how would the Federal Reserve make money or profit if the fund rate and the policy rate were the same? I don't think that they would make the fund rate the same as the policy rate because it could hinder their control over inflation.

Interesting Tidbit:
Whats ineffective and absurd is that the White House Budget and Management office is saying that the $787 billion stimulus package has saved 2.4M jobs. That's $327,916.66 spent per 'saved' job. They would have been better giving each US citizen $1,000 free with no strings attached to go spend.

schultzz.at

January 27, 2010 at 05:57 AM ET

The funds rate is the interest rate charged by banks lending to each other in the overnight market. The Fed is setting a target for this rate, but it is has to implement this target via 'Open Market Operations', typically buying and selling of Treasury Securities.
My point is that the huge amount of excess reserves would require a massive selling of Treasuries/MBS in order to tighten policy.
Therefore, if they adopt the deposit rate as their main policy tool, which is the interest rate they pay banks for excess reserves, they would have a more direct control over short term rates. And they would avoid disrupting Treasury and MBS markets.
Lets see, may be we get a hint in today's statement or in the minutes in 2 weeks.

Another Tidbit:
A local government in Austria does exactly that: Handing out cash to citizens (literally) and giving fuel away below market prices. They financed a soccer stadium, a hotel project and election campaigns. The financing was done via a bank backed by local government guarantees worth 18 billion euro. They were never even thinking about living up to these guarantees with local government revenues about 2 billion euro.

In 2007 a majority of the bank was sold to a bank owned by the German state of Bavaria. Insider knowledge was circulating and 100 'investors', including a former Austrian finance minister, made a quick buck.

In late 2009 it became obvious that the bank was bankrupt. The Bavarians 'sold' the bank for 1 euro to the Austrian Federal Government.

The Federal Government now owns a bank which has to pay fees to the local government for the 18 billion worth of 'guarantees'.
Tom Schultz.

alexjbrandt

January 27, 2010 at 04:51 AM ET

edit:

Make that $2,588.81 per citizen

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About The Author

Kathy Lien began her FX trading career 10 years ago at J.P. Morgan Chase. After graduating New York University’s Leonard Stern School of Business at the age of 18, Kathy joined the bank's interbank FX trading desk and eventually moved to the cross markets proprietary trading desk. In the interbank market, her ability to create solid fundamental and technical analysis from the myriad of information on the market helped her trade forex spot and options. Her experience eventually led her to be chief strategist at Daily FX where she worked until she joined GFT in 2008.

With her knowledge of forex, as well as her experience trading other products, such as interest rate derivates, bonds, equities, and futures, Lien has built a reputation as an international currency analyst. She is frequently quoted on CNBC, Bloomberg, Fox Business and Reuters. Lien has also written for publications like Active Trader, Futures, and SFO magazine. She is the author of the newly updated Day Trading the Currency Market: Technical and Fundamental Strategies to Profit from Market Moves, and the co-author of Millionaire Traders: How Everyday People Are Beating Wall Street at Its Own Game with Boris Schlossberg.

To buy Kathy’s newly updated Day Trading and Swing Trading the Currency Market: Technical and Fundamental Strategies to Profit from Market Moves, click here.