FOMC Rate Decision Could Add Pressure on Dollar

Last updated 12/15/2008 5:24 PM ET (GMT -5) 0 Comments - Add your comment

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Kathy Lien

Director of Currency Research, GFT

THE STORIES IN THE CURRENCY MARKET

• US DOLLAR: FOMC RATE DECISION COULD ADD PRESSURE ON DOLLAR
• EUR/USD: BREAKS 1.35, ON ITS WAY TO 1.40?
• BRITISH POUND: NEW LOW AGAINST EURO
• AUD/USD: CAUTIOUS RALLY AHEAD OF RBA MINUTES
• USD/CAD: OIL REVERSES GAINS AFTER OPEC COMMENT
• NZD/USD: STRONGER MANUFACTURING ACTIVITY
• USD/JPY: TANKAN TANKS, JAPAN ANNOUNCES NEW STIMULUS

EXPECTATIONS FOR UPCOMING FED MEETINGS

US DOLLAR: FOMC RATE DECISION COULD ADD PRESSURE ON DOLLAR

In Friday’s Daily Currency Focus, we argued that going into the FOMC rate decision, the US dollar could continue to weaken. The sheer reality is that by Tuesday afternoon, the US dollar will be either the lowest or second lowest yielding G10 currency is driving the dollar lower against all of the major currencies today. Although the Empire State manufacturing survey and industrial production numbers beat expectations, they still reflected deterioration from the prior month. Foreign demand for US securities plunged in the month of October, serving as a double whammy for the US dollar. Tuesday’s FOMC meeting will be remembered for decades to come as the Federal Reserve brings interest rates down to the lowest level this generation has ever seen. With 2 realistic options on the table and economist and traders divided on how much the Fed will cut interest rates, the only certain outcome is significant volatility for the currency market. No matter how you look at it, an interest rate of 0.50 percent is just as unattractive as an interest rate of 0.25 percent.
Federal Reserve: 50bp vs. 75bp The decision of cutting interest rates by 50 or 75bp is really a decision of how quickly the Federal Reserve wants to formally move to Plan B, or Quantitative Easing. If rates are not taken to 0.25 percent tomorrow, then we could see that level reached in the first quarter of 2009. Fed funds contracts are currently trading at 0.15 percent, which means that any rate cut by the Fed will only be symbolic. The futures contracts are pricing in a 68 percent chance of a 75bp rate cut and a 32 percent chance of a 50bp cut, but only 11 out of the 95 economists surveyed by Bloomberg expect interest rates to be cut by more than 50bp. Either way, someone will be proved wrong tomorrow and that could trigger a big move in the US dollar. Economic data has deteriorated significantly since the last monetary policy meeting and in our opinion, the right thing for the Fed to do is to cut interest rates by 75bp tomorrow and not delay the inevitable. With the US economy falling into a deeper recession, rationing monetary policy stimulus now could be counterproductive. However, the Federal Reserve may not want to back themselves into a corner by taking interest rates down to 0.25 percent so quickly and therefore many economists argue that a 50bp rate cut is the most likely scenario. Another reason why the dollar is selling off is because if the Fed eases by only 50bp, they could still signal that interest rates are headed to zero, which would be negative for the US dollar. The only reason why the dollar could rally following the rate decision would be if the Fed signals to the market that zero interest rates is not a possibility. Unlike Japan, deflation has yet to hit the US and zero interest rates could intensify problems that the repo market and money market funds are already facing. Demand is waning in the repo market as the return is insufficient to cover the risk of failure. For more on the FOMC Meeting and what the statement could entail, read our FOMC Preview.
What the TIC Data Signals about Foreign Demand The surprisingly weak Treasury International Capital flow report did not put a dent into the US dollar. However, that does not draw away from the fact that foreign demand for dollar denominated securities has decreased significantly. In the month of October, demand for long term US securities rose a measly $1.5 billion, the weakest in more than one year. A closer look at the data indicates that foreigners sold stocks, corporate bonds and Fannie and Freddie debt. The rise in foreign demand for short term securities represents a dramatic shift in investor appetite. With US bonds yielding next to nothing and the Dow Jones Industrial Average plunging close to 30 percent since the beginning of the third quarter, there is no wonder that foreigners are looking elsewhere for yield. As our colleague Boris Schlossberg said in his note this morning, the Madoff affair could deal an even bigger blow to foreign demand for dollars as Mr. Madoff may have tipped the balance of power back to European assets irrespective of the problems in the continent. In addition to the FOMC rate decision tomorrow, we are also expecting the release of consumer prices, housing starts and building permits. Softer producer prices and overall weakness in the US housing market should lead to more dollar bearish numbers.

EUR/USD: BREAKS 1.35, ON ITS WAY TO 1.40?

The strongest currency in the foreign exchange market today was the Euro, which surged 330 pips or close to 2.5 percent against the US dollar. Unlike other currencies which rallied on nothing more than US dollar weakness, members of the European Central Bank continued to suggest to the market that an interest rate cut in January is not a done deal. This morning, Ordonez confirmed that ECB President Trichet has been very clear that their options are wide open next month. This includes leaving rates unchanged or cutting by any amount depending upon inflation. The advance numbers for service and manufacturing PMI are due for release tomorrow – the price component of these reports could help the ECB with their decision. After slashing interest rates by 75bp at their last meeting, Trichet was quick to point out that future cuts would not be as sharp. However, we are beginning to see a pretty cohesive shift in the comments from ECB officials. In the past, the ECB has always tried to prepare the market for any major changes to monetary policy with the hope that when the actual announcement is made, it would lead to the least amount of volatility possible. The ECB hates surprises and certainly does not play any games when it comes to sending messages to the market. Therefore their recent comments suggest that they are seriously considering leaving rates unchanged in January. At a time when the market expects a historically significant rate cut from the US Federal Reserve that would take interest rates to a cyclical low, the not so dovish comments from the ECB has sent the EUR/USD soaring above 1.35 and back towards 1.40.

BRITISH POUND: NEW LOW AGAINST EURO

Despite the British pound’s recovery against the US dollar today, it fell to a new record low against the euro. The currency pair finally took out 90 cents but failed to hold that level as the British pound’s rebound against the US dollar gained momentum. On Friday, we talked about how we expect the aggressive interest rate cuts by the Bank of England and the weakness of the currency to drive a recovery in the UK economy in 2009. In contrast, the more restrictive monetary policy in the Eurozone and the strength of the Euro against the British pound could hurt the Eurozone economy going forward. UK consumer prices are due for release tomorrow. Given the fact that PPI numbers were mixed and the British pound has weakened materially, we may not see a large decline in consumer prices.

AUD/USD: CAUTIOUS RALLY AHEAD OF RBA MINUTES

US dollar weakness drove the Canadian, Australian and New Zealand dollars higher today. Commodity prices were mixed with oil giving back its earlier gains and gold prices rising $18 an ounce. Like shorting the US dollar, long gold has been a pretty clear trade going into Tuesday’s FOMC rate decision. The Australian dollar’s rally has been the least impressive ahead of the release of the RBA minutes. At their last interest rate meeting, the Reserve Bank of Australia cut interest rates by 100bp to 4.25 percent. This move was larger than the market expected and represents 275bp of easing since the beginning of the year. The minutes will shed more light on why the central bank felt compelled to make the larger move and whether they plan on cutting interest rates again. The Australian dollar’s rally was also held back by the country’s forecast that commodity exports could fall 10 percent next year. Meanwhile of the 3 commodity currencies, the New Zealand saw the most material rally thanks to the rebound in manufacturing activity in the third quarter. There was no economic data from Canada but oil prices reversed after OPEC said they may not be able to counteract the drop in prices.

USD/JPY: TANKAN TANKS, JAPAN ANNOUNCES NEW STIMULUS

With interest rates near zero, Japanese policy makers and central bankers are forced to contrive new efforts in fighting their economic woes. In the face of weak business confidence, Japan announced a new fiscal stimulus plan, totaling ¥23 trillion. Although the expansionary policy will boost government spending dramatically, and directly widen the budget deficit, it will most likely have a negligible impact on growth as slower global growth offsets the plan. In addition to this announcement, the government is also taking steps to start purchasing commercial paper and providing direct capital injections into the banks. Benefits from stimulus packages can be short-lived and have so-far been a disappointment to market participants. This may be part of the reason why the Tankan index of business confidence suffered its sharpest decline in 30 years. The report, which fell from -4 to -36 this month, has been a very consistent indicator of economic activity and monetary policy. However, its effectiveness will no longer be in predicting rate cuts, but stimulus-related plans like what we received today. Tonight, Japan will release the tertiary Index, a key indicator of the strength of Japan’s domestic markets.

EUR/USD: Currency in Play for Next 24 Hours

The EUR/USD will be the currency in play for the next 24 hours. Of course, the major headline for the US, and perhaps the most significant market moving event of the month, will be the Federal Reserve rate cut announcement at 2:15 pm ET or 19:15 GMT. The US will also release Consumer Prices and Housing Starts at 8:30 am ET or 13:30 GMT. The Euro-zone will have Manufacturing and Services PMI at 4:00 am ET or 9:00 GMT. The EUR/USD is continuing its remarkable rally today, having seen gains for the last six consecutive trading days. You would have to go back to a rally in October of 2007 to see a similar feat. However, as always, resistance is close by. This one in particular is the 38.2% retracement from July highs to October lows at 1.3745, which also coincides with a gap down and several highs placed during the consolidation period in October. A possible support exists at 1.3300, or the high of October 30th. The breaking of the 38.2% level will be crucial in justifying the validity of this strong advance.

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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.