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Monday January 7, 2008 - 23:00:52 GMT

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Forex Research - US Dollar Recovers, but Watch Out for Growing Rate Cut Expectations


Monday, 07 January 2008 21:16:39 GMT

Written by Kathy Lien, Chief Currency Strategist

• Will the ECB Raise Interest Rates?
• British Pound Continues to Sell Off, Rate Cut Expectations Edges Higher

US Dollar Recovers, but Watch Out for Growing Rate Cut Expectations

Friday’s exceptionally weak December non-farm payrolls report led to sharp losses in the US dollar. Today the dollar recovered which is not surprising given the extent of the prior sell-off. However just because the dollar has rallied does not mean that fears of a continued slowdown or a US recession have abated. Harvard Economist Martin Feldstein argues that the latest employment report puts the odds of a recession at more than 50 percent. This may explain why rate cut expectations are continuing to rise with the probability that the Federal Reserve will lower interest rates by 50bp on January 30th now at 70 percent compared to 66 percent on Friday and 0 percent a week ago. Oil prices have fallen back towards $95 barrel, which will help to make the Fed’s decision easier. If inflation is not such a pressing issue, the central bank will be able to focus on doing all that is needed to spur growth. We continue to believe that even though a 50bp rate cut is possible, it is too early for the Federal Reserve to make up their mind. If consumer prices and retail sales remain strong, the central bank may opt to cut interest rates less aggressively. If they confirm the overall weakness of the US economy and the growing threat of a recession however, then the Federal Reserve may have no choice but to cut by 50bp. Pending home sales are due for release tomorrow along with consumer credit. Fed Presidents Plosser and Rosengren will also be giving speeches on the economic outlook. We expect the housing market data to continue to remain weak and the Fed’s economic outlook to remain dismal. As a result, unless the data suggests otherwise, we expect further dollar weakness.

Will the ECB Raise Interest Rates?

The European Central Bank will be announcing their monetary policy decision this Thursday. They are not expected to raise interest rates even though their steady growth and strong inflation numbers suggest that they could. Oil prices have been very volatile which will make it difficult for the central bank to decide whether inflationary pressures are here to stay. For the time being, the risk of another run to $100 oil is still strong enough for the ECB to warn that they will do all that it takes to prevent second round effects. Even though the monthly rate of PPI growth was right in line with expectations, the annualized pace of growth accelerated from 4.0 to 4.1 percent. The business climate and economic indices were also stronger than expected. Tomorrow we are expecting Germany factory orders and Eurozone retail sales. The improvement in Germany’s labor market should keep consumer spending healthy. Meanwhile the Swiss franc sold off against all of the major currencies despite steady employment. The seasonally adjusted jobless rate remained unchanged at 2.6 percent, a five year low. There are no further releases from Switzerland this week, but the latest piece of data does support another interest rate hike.

Visit the Euro Currency Room for resources dedicated specifically to the Euro.

British Pound Continues to Sell Off, Rate Cut Expectations Edges Higher

The British pound continues to be one of the weakest currencies in the foreign exchange market. Since the beginning of December, it has fallen over 1000 pips. Even though economists are not looking for the Bank of England to cut interest rates on Thursday, traders have priced in a 40 percent probability of a 25bp rate cut. This means that if rates are left unchanged, the British pound should rally because part of the recent weakness is due to the pricing in of potential easing. Before the BoE rate decision, there are a number of UK economic releases due for release including the BRC retail sales monitor, their shop price index, nationwide consumer confidence and the trade balance.

Visit the British Pound Currency Room for resources dedicated specifically to the Euro.

Australian, New Zealand and Canadian Dollars Diverge

The commodity currencies diverged significantly today with the Australian and New Zealand dollars rising while the Canadian dollar edged lower. New Zealand was the only country to report any economic data and the worse than expected trade balance figures did little to explain the latest move. In fact, the NZDUSD did not rally until the last 2 hours of the US trading session when the Dow edged back into positive territory. This move is completely driven by a recovery in risk appetite because both gold and oil prices are lower. As for USD/CAD, it has broken out to the upside and looks poised for further gains. This dovetails well into our belief that Canadian employment was particularly weak in December; the data is due for release on Friday.

Tell us what you think on the Canadian dollar Forum.

Japanese Yen Crosses Recover Modestly

The Japanese Yen crosses recovered modestly thanks to the end of day rally in the Dow. Both the monetary base and vehicle sales figures were weaker than the prior month. Although it may be tempting to hope that we may be headed for more gains from here on, traders need to be careful because the moves today are unconvincing. Today’s 27 point rally in US stocks hardly erases the 246 point loss on Friday. Tell us what you think what will happen to the Yen crosses in our latest Carry Trade: Buy or Sell poll.

Visit the Japanese Yen Currency Room for resources dedicated specifically to the Euro.



By Kathy Lien, Chief Strategist of

Contact Kathy Lien about this article at [email protected]


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