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Dollar: Should The FED Raise Discount Rate?

Last updated 3/18/2010 5:10 PM ET (GMT -5) 1 Comments

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Kathy Lien

Director of Currency Research, GFT

THE STORIES IN THE CURRENCY MARKET

• DOLLAR: SHOULD THE FED RAISE DISCOUNT RATE?
• EUR/USD: EU LEADERS RELUCTANT TO OFFER GREECE A LIFELINE
• GBP/USD: EMPLOYMENT GIVES NEW LIFE TO THE POUND
• USD/CAD: UPSIDE POTENTIAL FOR RETAIL SALES
• AUD/USD: HITS RECORD HIGHS AGAINST EURO
• NZD/USD: GOLD UP, OIL DOWN
• USD/JPY: VOLATILITY CONTRACTS

EXPECTATIONS FOR UPCOMING FED MEETINGS

DOLLAR: SHOULD THE FED RAISE DISCOUNT RATE?

Although the price action in the forex market today suggests that currency traders are nervous, the jitteriness was not shared by equity or bond traders who sent stocks to new yearly highs and pushed bond prices lower.  Traders bid up the U.S. dollar against every major currency except for the New Zealand dollar which staged a very modest rally.  The biggest story out of the U.S. was not necessarily economic reports but rather the rumor that the Fed could raise their discount rate mid-day.  This never materialized but it brought up a good question about whether the central bank should narrow the gap between the discount rate and the Fed funds rate.

Should the Fed Raise the Discount Rate?

Rumors of a discount rate hike stirred a flurry of intraday activity in the U.S. financial markets intraday.  The reason why we think this rumor is worth discussing is because it illustrates the different steps the Fed could take before actually raising the Fed funds rate.  If you recall, the difference between the Fed funds rate and the discount rate is that the Fed funds rate is the rate that banks charge each other for loans while the discount rate is the rate that the Fed charges to commercial banks and other depositary institutions on loans.  Raising the discount rate would help the Fed normalize monetary policy without affecting households.  Prior to this easing cycle, the gap between the discount rate and the Fed funds rate was 100bp while the current spread is 50bp. Therefore this move is one that the Fed will eventually make but they will most likely telegraph it weeks in advance just like they did before they raised the discount rate last month.   In fact, we would not be surprised if the Fed telegraphed this move in their next monetary policy statement and then follow through with it shortly thereafter.  

U.S. Data Will Not Alter the Fed’s Course

Meanwhile U.S. equities reached new 1 year highs this morning but currencies failed to follow. Like producer prices, consumer price growth fell short of expectations last month. CPI was flat in February due primarily to the large drop in gasoline prices. Excluding food and energy, consumer prices rose 0.1 percent. The latest inflation reports indicate that inflationary pressures are modest, but we continue to believe that the dip in inflation will be temporary because gas and oil prices have risen significantly so far this month. The CPI and PPI numbers have simply bought the Fed time and allowed them to gradually ease out of their ultra easy monetary policy. The sell-off in the dollar against the Yen was short-lived as traders realized that CPI numbers will not be a game changer for the U.S. dollar. Instead they found comfort in faster manufacturing activity reported in Philadelphia. Despite the prior dip in manufacturing activity in the NY region, the Philly Fed survey rose for the second month in a row to 18.9 from 17.6. Unlike the housing market which the Fed singled out as an area of concern in their FOMC statement, the manufacturing sector continues to recover. As for the rest of this morning's economic reports, jobless claims dipped but not as much as the market had anticipated. Even though the number of people receiving extended benefits decreased, the number of people receiving emergency benefits and continued benefits increased. The current account deficit also expanded from -$102.3B to -$115.6B while leading indicators rose 0.1 percent.  No U.S. economic reports are due for release tomorrow which means it could be another day of quiet trading.  

EUR/USD: EU LEADERS RELUCTANT TO OFFER GREECE A LIFELINE

The euro sold off aggressively after it has become increasingly clear that members of the European Union will be more willing to support Greece in knocking on the doors of the IMF than to dig into their own pocketbooks.  Initially, the option of the tapping IMF was one that most members of the EU and the ECB ruled out.  However the inability of EU finance ministers to create a concrete contingency plan has forced certain countries like Germany to reconsider the IMF option.  Although tapping the IMF would be a huge negative for the Eurozone as a whole (imagine the reaction in the U.S. dollar if the U.S. government asked the IMF for help bailing out California), Germany apparently believes that it would be political suicide to ask their citizens to pay for the problems of another country.  This morning, German Chancellor Angela Merkel said in the absence of a willing European lender, the “IMF would probably have to be the way out right now if action were to be taken.”  She even went a step further to say that there should be a mechanism to expel countries out of the Eurozone if they persistently break the Treaty’s rules.  Although she made it clear that this was not a jab at Greece and is more of a long term consideration, it could still affect Greece if they fall back into their old ways after this crisis is resolved.  Greece has given EU leaders 1 week to come up with a financial aid mechanism.  If they fail to do so, Prime Minister Papandreou said he may turn to the IMF.  EU leaders have a meeting next week to decide on if and how to provide a lifeline for Greece.  French President Sarkozy does not support seeking IMF assistance so it should be a heated meeting.   Based upon the latest comments from Merkel, we are not very optimistic that they will come to a resolution, particularly since EU members have repeatedly stressed that Greece does not need a bailout at this time. The euro also received no help from economic data.  Both the trade balance and current account surpluses turned into a deficit in January due to weakness in Germany.  Meanwhile the Swiss Franc fell to the lowest level against the euro since October 2008 and the lowest level against the British pound since November 2007.  The weaker than expected trade numbers were offset by stronger industrial production.  At some point the Swiss National Bank will feel compelled to intervene and we believe that the franc is nearing that level.  

GBP/USD: EMPLOYMENT GIVES NEW LIFE TO THE POUND

Weaker than expected U.K. economic data forced the pound to give up its gains against the U.S. dollar but greater problems in the Eurozone helped sterling strengthen against the euro for the third trading day in a row.  In the month of February, mortgage approvals rose only 48k, compared to a forecast of 54k.  Public sector net borrowing rose 12.4B last month which was slightly less than the market had anticipated but still the highest level of borrowing ever for the month of February.  So far this year, the U.K. government has borrowed GBP131.867, pushing debt as a percentage of GDP above 60 percent.  However despite these staggering numbers, sterling traders should find comfort in the idea that the U.K. government is on track to undershoot its forecasted borrowing needs of GBP170.4 billion in the year ending in April 2010.  If the U.K. can consistently borrow less than forecast, there would be a lower risk of a downgrade.  There has been an interesting turn in the events for the U.K. this week and we strongly believe that the recent rally in the British pound has encouraged short sterling traders to unwind some positions.   Yet it is also important to realize that the U.K. economy is not out of the woods.  The CBI Industrial Trends survey deteriorated slightly in March which suggests that manufacturing activity may have slowed.  There are no additional economic reports due from the U.K. this week.  

USD/CAD: UPSIDE POTENTIAL FOR RETAIL SALES

Of the three commodity currencies, only the New Zealand dollar strengthened against the greenback.  The rally in the kiwi was quite bizarre considering that consumer confidence deteriorated.  Visitor arrivals and credit card spending figures are due for release this evening but these are rarely market moving reports for the kiwi.  The market’s focus continues to be on the Canadian dollar, which has taken what we believe to be a temporary reprieve from its path towards parity with the U.S. dollar.  Canadian economic data has been very strong and this morning’s international securities transaction report was no exception.  Foreign demand for Canadian dollar denominated securities rose for the fourth consecutive month.  Friday will be a particularly busy day for the loonie with consumer prices and retail sales due for release.  Although the strength of the CAD could push down inflationary pressures, we expect retail sales to be strong.  Canada has reported positive job growth 7 out of the past 11 months while wholesale sales rose the most in 3 years. Strong consumer spending numbers could be just what the Canadian dollar needs to push itself to parity with the U.S. dollar.  Canadian officials have been extremely relaxed about the move in the loonie which is yet another reason why we expect further gains.  Finally, the Australian dollar ended the NY trading session slightly lower against the greenback.  There was no major data released overnight and nothing is expected this evening.  

USD/JPY: VOLATILITY CONTRACTS

For the past 6 trading days, the Japanese Yen has ended virtually unchanged against the U.S. dollar.  In fact, USD/JPY has been contained within a 148 pip trading range since March 8th and as a result, one and three month option volatilities have fallen to the lowest level in 19 months.  This of course suggests that a breakout in USD/JPY is imminent.  However there is no U.S. economic data on the calendar tomorrow which means that traders will most likely have to wait until next week to see any big moves in the currency.  Aside from the kiwi, the Japanese Yen strengthened against every major currency despite weaker economic data.  The BSI All Industry activity index fell from -1.9 to -2.4 in the first quarter and from 13.2 to 4.3 for the large manufacturing sector.  Leading indicators were also revised slightly lower while the conicnident indicator was revised higher.  Department store sales are due for release this evening and unfortunately consumer spending will probably remain weak.  

USD/CAD: Currency in Play for Next 24 Hours

USD/CAD will be the currency pair in play for the next 24 hours. Canada expects an array of economic releases including Consumer Price Index figures at 11:00 GMT or 7:00AM EST and Retail Sales at 12:30GMT or 8:30AM EST. Entrenched in the Sell Zone of the Bollinger bands, USD/CAD has made big strides towards parity. The pair still remains within the Sell Zone, but is rebounding after a prolonged downtrend. The key level of resistance which may stop the current rebound is the first standard deviation at 1.0885. Support is currently placed at a one-year low benchmark of 1.0070, a break of which will push the pair towards parity.

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Comments (1)

Bushnaq

March 19, 2010 at 05:04 AM ET

I guess the swiss bank intervention has been delayed so far because they are waiting for recovery signals on EUR, I mean it is hard for them at the time being to buy EUR in big amounts thus taking such a big risks with all EUR current bad conditions, so maybe they prefer no not go long on EUR/CHF until they have some signals that EUR is stabilizing, other than that they would prefer strong CHF rather than buying weak EUR, What do you think about this ?

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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.