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Forex Research - Why the US Dollar Will Fall Further?

Wednesday, 30 January 2008 22:22:33 GMT

Written by Kathy Lien, Chief Strategist

• USDJPY Headed to 105
• Eurozone Rates Are Now 100bp Higher than US Rates

Why the US Dollar Will Fall Further?

The Federal Reserve cut interest rates by 50bp to 3.00 percent.  In a little more than one week, the US central bank has lowered interest rates by 125bp, turning the US dollar into a de facto carry trade funding currency.  The greenback now yields 100bp less than the Euro and the British pound and 525bp less than the New Zealand dollar.  At the same time, it only offers 25bp more in yield than Switzerland, but a comfortable advantage of 250bp over the Japanese Yen.  These interest rate differentials provide a perfect explanation for the price action in the currency market post FOMC.  The dollar dropped the most on a percentage basis against the New Zealand dollar and the least against the Japanese Yen.  But the dollar’s weakness is not over.  According to the FOMC statement, the Fed is still worried about financial market conditions, tight credit, the stability of the labor market and a further contraction in housing.  Although they believe that their recent efforts will offset some of the downside risks to growth, the tone of the FOMC statement indicates that this rate cut will not be their last.  We still expect US interest rates to fall to least 2.50 percent before this easing cycle is over.  The pace of rate cuts however will begin to slow.  Last week, the Fed cut by 75bp, today they cut by 50bp and on March 18, we expect only a quarter point rate cut.  The economy will need time to absorb the easing and even though the Fed does not think that inflation is an immediate threat, by lowering interest rates too rapidly, they risk stoking inflationary pressures.  By cutting interest rates 50bp instead of 25bp, we commend the Fed for being ahead of the curve.  This will hurt the outlook for the US dollar in the near future, but it will pay off in the second half of the year.  With the FOMC rate decision behind us, the next big event risk is Friday’s non-farm payrolls report.  There is a decent chance that January job growth will be very strong. ADP reported that 130k new jobs were added to US payrolls last month which dovetails well into the surprisingly low level of jobless claims that we have seen in recent weeks. The four week moving average of claims is now at a 3 month low which indicates that non-farm payrolls at bare minimum will be more than the 18k jobs that were created last month. In fact they could be as high as 85 to 100k.  Before that on Thursday we are expecting personal income, personal spending and Chicago PMI. 

USDJPY Headed to 105

The Japanese Yen crosses tried to hold onto their gains following the Fed’s interest rate cut, but they failed to do so as the 185 point post FOMC rally in the Dow turned into a 37 point loss.  USDJPY proceeded to sell-off aggressively, leading to 100 point slide in USDJPY.  We expect this weakness to continue since a 250bp interest rate differential between the US dollar and Japanese Yen makes long USDJPY an increasingly unattractive long.  Unfortunately this will probably drag down all of the other carry trade currencies.  Also, the rate cut should have been positive for the Dow, but the intraday reversal points suggest further weakness in equities. 

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

Eurozone Rates Are Now 100bp Higher than US Rates

Leading up the Federal Reserve interest rate decision, the EUR/USD had been trapped within a tight 100 point trading range, but as soon as the Federal Reserve announced the larger rate cut, the Euro skyrocketed. The reasoning is simple; Eurozone interest rates are now 100bp higher than US rates. ECB rates are expected to remain steady, but US rates will come down further, which is why the EUR/USD could make a run for its all time high.  There has been no major deterioration in Eurozone economic data.  Retail PMI actually advanced from 46.0 to 48.1 thanks largely to a sharp acceleration of spending in France. German retail sales and employment are due for release tomorrow.  Both numbers are expected to be firm. Unemployment improved in the month of December, which should boost consumer spending.  Meanwhile, Swiss economic data continues to deteriorate with the KoF leading indicator falling from 1.84 to 1.70.  This will matter little to the SNB however as they intend to keep interest rates steady for the foreseeable future. 

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

Fading Strength in the British Pound

The British pound had a nice rally last week, but the strength of the currency pair is fading.  Unlike many of the other major currencies, the British pound failed to hold onto its gains against the US dollar.  Housing market data from the UK continues to disappoint with consumer credit and mortgage approvals falling short of expectations.  Nationwide house prices are due for release tomorrow and we expect this housing market indicator to continue to reflect the overall vulnerability of the sector.  Despite the backlash that he received for his delayed reaction to the August credit crunch, Bank of England Governor Mervyn King has been appointed to a second five year term as the head of the central bank.  Despite the fact that we expect the dollar to continue to weaken against most of the major currencies, the British pound could actually underperform both the Euro and US dollar.  We also think that a possible top is in place at 1.9950 in the British pound.

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

Canadian, Australian and New Zealand Dollars Continue to Appreciate

The Canadian, Australian and New Zealand dollars continued to extend their gains despite a retracement in gold prices and a marginal rise in oil prices.  This is largely due to the fact that the US dollar now yields 100bp less than the Canadian dollar, 375bp less than the Australian dollar and 525bp less than the New Zealand dollar.  There was no data out of Canada, but skilled vacancies in Australia dropped from the prior month.  The New Zealand trade however soundly beat the market’s expectations.  A strong rise in exports took the trade deficit down to the smallest level in more than two years.  Australian private sector credit and Canadian GDP are due for release tomorrow.

Tell us what you think on the Canadian dollar Forum.

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By Kathy Lien, Chief Strategist of DailyFX.com

Contact Kathy Lien about this article at klien@dailyfx.com






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