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Saturday December 8, 2007 - 01:21:38 GMT

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Forex Research - Time for FOMC! Expect the Fed to Cut by 25 and Not 50


Friday, 07 December 2007 21:24:28 GMT

Written by Kathy Lien, Chief Strategist

• Euro: More Reason to Believe Trichet Could Raise Interest Rates
• Can the Pound Recovery Continue?

Time for FOMC! Expect the Fed to Cut by 25 and Not 50
Non-farm payrolls were a big disappointment today because it failed to trigger any volatility in the currency market. The report was mixed with job growth slowing and average hourly earnings growing in the month of November. The ADP report released on Thursday had forecasted payroll growth in excess of 200k and they couldn’t have been more wrong. Even though analysts had rushed to revise up their official estimates on the heels of the ADP, they should have followed the signals given by all of the other employment related reports. Even though the currency market hasn’t budged, rate cut expectations for Tuesday’s FOMC meeting has. Earlier this week, the chance of a 25 vs. 50bp rate cut was close to fifty-fifty. Now, the odds for a half point cut are less than 25 percent because the payrolls figure was not bad enough to warrant a larger rate cut. Managing expectations has become a big component of the Fed’s job these days whether they are willing to recognize it or not. If the market is pricing in a quarter point cut and the Fed under delivers by leaving rates unchanged, they risk triggering a sharp repricing of the yield curve. If they over deliver by cutting interest rates 50bp, it could cause many people to wonder whether some bad news has yet to be discovered. The Federal Reserve’s interest rate decision has the power to shift the trend in the market, but they will probably contain volatility by releasing a more cautious FOMC statement that points out the risks of both growth and inflation. If the Fed fails to give the markets the clarity that it needs, producer prices, consumer prices and retail sales will. If inflation and spending remains strong, then the recession story gets shelved for the time being and the dollar could see a short term recovery. The other releases that we are also expecting are pending home sales, the US trade balance, import prices and industrial production.

Euro: More Reason to Believe Trichet Could Raise Interest Rates
Is the European Central Bank just talk or will they actually follow through with an interest rate cut? Unfortunately, this question will not be answered until the next ECB meeting on January 10th at the earliest. With each passing day however we have more reason to believe that the ECB could actually make good on their threats. This morning, German industrial production was stronger than expected while the OECD leading indicator for the Eurozone remained unchanged at 98.4. Even the Eurogroup which has previously called for the ECB to step in and stop the Euro from rising now says that the economy is proving resilient in the face of shocks. In the week ahead, we do not have many important pieces of data other than the German ZEW survey, which has been losing its market moving potential because it has repeatedly called for a slowdown that has yet to unfold. This means that US data will probably dictate the movements in the EURUSD. Meanwhile aside from the Federal Reserve, the Swiss National Bank also has an interest rate decision. They are widely expected to leave rates unchanged, but there is a risk for a surprise rate hike or at least hawkish commentary from the SNB.

Can the Pound Recovery Continue?
The British pound recovered for the second day in a row which says a lot because it comes on the heels of the first interest rate cut in two years. The futures market is still pricing in 50 to 75bp of easing next year and if expectations are correct, then the pound should continue lower. However there are often retracements within a broad downtrend and we expect to see one at the beginning of next week. Before Tuesday’s FOMC meeting, we are expecting producer prices and the trade balance. The UK trade deficit should improve because the export component of manufacturing PMI accelerated last month. We already know that inflation is a problem because the latest monetary policy statement talked up the risks to short term inflation. However anything goes after the FOMC meeting because the US rate decision could shift the near term outlook for many currency pairs. On Wednesday we also have UK employment data which we expect to be pound bearish.

Strong Employment Numbers Drive Canadian Dollar Higher
USDCAD sold off for the second day in a row following much better than expected Canadian employment data. If you read yesterday’s Daily Fundamentals, the upside surprise should not much of a surprise because we said that the employment component of the IVEY PMI already forecasted stronger employment growth. The market was looking for only a 15k rise, but instead employment grew by 42k. Although the unemployment rate edged higher from 5.8 to 5.9 percent, the participation rate hit a record high of 63.8 percent which means that more people are encouraged to join the workforce. The Australian and New Zealand dollars did not fare as well however following the drop in Australian construction PMI. Although there isn’t a lot of data from the commodity producing countries next week, the data that we do have can be very market moving. This includes the Canadian trade balance, Australian employment and New Zealand retail sales.

Carry Trades Rebound as Dow Holds Onto Gains
With the Dow holding onto its recent gains and Japanese third quarter GDP revised downwards, the Yen crosses are up across the board. Weak capital expenditures and domestic demand is preventing the Japanese economy from recovering and unless the government finds a way to boost spending, growth will remain soft. For that reason, we do not expect any remarkable strength in the fourth quarter Tankan report which measures business activity and sentiment. The outlook of the Yen crosses continued to be tied to the outlook of the Dow. If the US stock market extends its gains, so will carry trades but if it begins to top out, watch out for another wave of carry liquidation.




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