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The Fed Fears The Worst

Last updated 1/6/2009 5:36 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

• THE FED FEARS THE WORST
• EUR/USD: INFLATION BELOW DESIRED RANGE MAY WARRANT A LARGE RATE CUT
• GBP/USD: BoE IS EXPECTED TO BRING INTEREST RATES DOWN TO HISTORIC LOWS
• USD/CAD: DEFLATION REARS ITS UGLY HEAD
• AUD/USD: REACHES 2 1/2 MONTH HIGHS
• NZD/USD: HIGHER ON STRENGTHENING COMMODITIES
• USD/JPY: THE FALLING YEN IS MUSIC TO THE BoJ’s EARS

EXPECTATIONS FOR UPCOMING FED MEETINGS

THE FED FEARS THE WORST

Trading in equities very closely mirrored yesterday’s volatile session. It is clear that investors are still uncertain, as direction in the Dow has been largely range-bound. Equities have swerved between two extremes, at one time positive by more than a hundred points. Even though the excitement and enthusiasm behind the newly proposed relief program has managed to give equities a new leg, we are still undeniable seeing the levels of concern that have pervaded the markets for most of last year. This level of fear was a big factor that led to the original implosion of the equities market. Trading in the dollar has been likewise mixed, with strength against the euro and yen, but weakness against the pound and commodity currencies.

The Minutes Reiterate the Obvious

“The economic outlook will remain weak for a time and the downside risks to economic activity will be substantial”. In one sentence the FOMC Minutes managed to convey the board’s pessimism for the coming economic year. The minutes noted problems ranging the gamut from deflation, weak consumer and business spending, slowing exports, strained credit markets, and a severely depressed manufacturing sector. The list goes on, giving the Fed reason to sharply revise their economic outlook to the downside. However, these developments are expected. After all, in a decision that brought the target rate down to a “range” between 0% and 0.25%, things would have to be dire. A few optimistic points came up, notably an improving Commercial Paper market and the potential for a return to modest growth by 2010. Luckily, the Fed seems committed to taking any and all possible actions to restore such sustainable economic growth.

Expectations for the next interest rate decision will see a complete shift to balance sheet issues. Obviously, at this point further rate cuts are off the table. We are merely awaiting the next initiatives to be announced that will officially put us on the quantitative easing road. The Fed is still expressing concerns, like that of the BoE and BoC, of which interest rate cuts have not yet trickled down to the masses of individual and business borrowers. It is likely that further initiatives will be focused on improving this disparity. The minutes informed us that, “participants discussed the merits of purchasing large quantities of longer-term securities”. The key idea of which is to lower yields so as to indirectly reduce borrowing costs. However, as we have seen, one does not always translate to the other. At this point, it seems almost blatantly obvious that the Fed will expand its purchasing of such long-term Treasuries. In effect, the market moving implications for the meeting will exist entirely in the unexpected. Possibilities of just such an occurrence could be the implementation of inflation or even a balance sheet target to further direct monetary policy.

Are We Pulling Off of Record Lows?

For once, the bevy of economic data that we are subject to has given the economy a small and temporary portion of breathing room. As indicators for such a conclusion we have seen that all reports issued today are either above last month’s figures or better than economists’ expectations. The Non-Manufacturing ISM was reported at 40.6, both higher than forecasts and prior figures. The strength of the services sector was a crucial component to offset the weakness in last week’s manufacturing ISM. However, this number is still the second worst on record. Factory Orders fell more than expected, posting a loss of 4.6%. Even though this figure was better than last month, we are in the mists of the worst consecutive two-month report on record. Pending Home Sales also offered a bit of optimism, showing an improvement over prior figures. However, once again the number was still far worse than expectations. Pending sales in the Northeast were the worst portion of the report. We have come to a point that economic data will likely be relieved off of some November lows; however the information still casts doubt onto the success of a market turnaround. Expected for tomorrow will be Challenger Job Cuts and ADP Employment, both important leading indicators for the strength of Friday’s employment situation.

EUR/USD: INFLATION BELOW DESIRED RANGE MAY WARRANT A LARGE RATE CUT

The euro is pounded by another round of troubling economic data. It is arguable that the Euro-zone is facing the brunt of the worst of the financial conditions that are circulating thus far this year. This is not to say that the US and UK are reporting stellar news, it is just that the lack of such significant interest rate cuts make the region a bit more vulnerable. This weakness is on display in today’s trading as the euro retreats across the board. The worst of the economic data is in the Consumer Price index, which fell to a new two year low at 1.6%. The significance of this report is that inflation has officially fallen below the ECB’s target range of acceptable price levels (the ECB’s official inflation rate target is slightly less than 2.0%). This single-handedly presents an overwhelming opportunity for the ECB to make another all-out attempt at a 75-100bp cut. Whether or not this seems reasonable, the ECB is still largely hesitant to make another drastic move as per a series of hawkish comments made by ECB President Jean-Claude Trichet. Among other reports, the services component of the PMI does not seem to be under the same amount of pressure as manufacturing. PMI Services showed positive surprises in the entire EZ region, except for France. Although the much anticipated rate decision is still more than a week away, we are still looking at this week’s data as a telling indication of the extent of an almost definite rate cut. Tomorrow, we will receive the German Unemployment Rate and Wholesale Price Index, along with the EZ Producer Price Index. Again, the inflationary reports will be a part of the key metrics behind next week’s decision.

GBP/USD: BoE IS EXPECTED TO BRING INTEREST RATES DOWN TO HISTORIC LOWS

The pound will likely take center-stage for the remainder of the week because the BoE is the first major central bank to make the rate decision this month. This makes today’s economic reports of key sensitivity to a rate cut prediction. The much expected 50bp rate cut would see rates at their lowest level in the central bank’s three hundred year history. A day of mixed data has shown Services PMI at 40.2, coming slightly off of its all-time low level. However, Nationwide Consumer Confidence fell to a new five-year low at 47, while House prices fell a staggering 15.9% to a more than 15-year low. Despite the harsh criticism inflicted by struggling economic data, the pound is off to a strong winning streak this year, particularly against the euro. The story of EUR/GBP has been one of the most impressive rallies last year, but the fundamental story has changed. Originally, the main factor behind the rally was the apparent hesitation of the ECB to lower rates, while the BoE was making cuts of monumental sizes. The story has changed in that many speculate that the aggressive UK monetary action may start to stabilize the economy this year. However, many are expecting that a deteriorating European economy will force the ECB to take some new drastic steps. The pound has since reaped the benefits, running on a two-day consecutive rally, seeing gains total as much as 500 pips. From here, the main event risk for the rest of the week for pound traders will be dependent on the BoE decision. There are no relevant data expected until the decision has been made.

USD/CAD: DEFLATION REARS ITS UGLY HEAD

Commodity currencies maintain their resounding strength. However, the carry trades are seeing much more progressed rallies than USD pairs. This is particularly due to the weak yen as opposed to any fundamental surprises from the high-yielders. Crude oil was pressing higher this morning once again, only to succumb to a pause in an otherwise strong rally. Gold turns around after earlier losses to finish the day higher by 1.0%. Once again, the economic situation in Canada is losing some of its appeal. For one, Raw Materials and Industrial Product prices both saw a new record decline. The deflationary virus seems to be taking its first steps throughout the globe. Concerns for the inability to acquire financing are being addressed today by Finance Minister Jim Flaherty. Although the Canadian situation does not seem as dire as that from the UK, US, and Japan, it is still being addressed by a task force to secure that lending does not become any more restricted. AUD/USD price action is reaching highs not seen since the middle of October. Continued market moving events will rest on the shoulders of tonight’s New Zealand Trade Balance and tomorrow’s Australian Retail Sales.

USD/JPY: THE FALLING YEN IS MUSIC TO THE BoJ’s EARS

The weakness of the yen continues for another day, tallying a sixth straight day advance in USD/JPY. This development is like music to the BoJ’s ears. The falling yen has single-handedly boosted morale among stock and bond traders alike. As we have all come to learn, the export-dependent country is severely disabled when the currency strengthens, producing reduced international demand. The destruction in international economies in addition to the flight to the safe haven for the yen has served as a double edged sword for the Japanese economy. Of course, before we can call an end to their struggles, it seems fitting to require more long-term stabilized yen depreciation. As of now, we can make no assumption that these rallies will continue to reverse the negative course of the last year. As a result of these developments, the Nikkei 225 is experiencing its longest winning streak for about a year and a half; the index is up more than thirty-five points in today’s trading. With the scarcity of Japanese data, it is possible that this rally will continue until the round of rate decisions offer a market moving stimulus.

EUR/USD: Currency in Play for Next 24 Hours

The currency in play for the upcoming 24 hours will be EUR/USD. This is due to German’s Employment Change which is set to be released at 8:55 GMT or 3:55 AM EST and Euro zone’s PPI which scheduled to be released around 10:00 GMT or 5:00 AM EST.

Since the beginning of the year EUR/USD experienced a drastic sell-off which has eradicated most of the gains established in the latter half of 2008. As a result the pair pierced through the first standard deviation of the Bollinger Bands, yet the pair retraced and is currently within the Trade Range Zone. Support is placed at 1.3320, which proved to be efficient as it was a low for this day. Further, the level is a 38.2% retracement of September high and October low of last year. Resistance is originating at 1.3800 which is a 20-day SMA. With volatility remaining above average there is a strong probability that either of the levels could be tested.

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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.