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Thursday February 21, 2008 - 01:08:19 GMT

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Not Good Enough for the US Dollar

Written by Kathy Lien, Chief Strategist

• British Pound Tanks As BoE Minutes Reveal Unanimous Support for a Rate Cut
• Warnings from the ECB Weigh on Euro

Not Good Enough for the US Dollar
It has been a very active trading day with market moving news coming from all four corners of the forex market. The US dollar was firm ahead of the NY open but reversed all of its gains by the end of the US session. The only two currencies that failed to rally against the US dollar were the lowest yielding ones which are the Japanese Yen and Swiss Franc. Although consumer prices and housing numbers were stronger than expected, the dollar’s knee jerk rally quickly evaporated as the market realized that inflation was not hot enough for the Federal Reserve to reconsider their intentions of lowering interest rates. This belief was validated by the minutes from the last FOMC meeting where the Fed cut interest rates by 50bp. At the meeting, the US central bank reduced their growth forecasts and increased their forecasts for inflation and unemployment. By the end of the year, they expect the unemployment rate to rise to as high as 5.3 percent. A pessimistic tone hung over the meeting with several members noting significant risks of a downturn in the economy. They felt that the combination of sharp equity market weakness and declining house prices would crimp consumer spending going forward. As a result, interest rates are expected to remain low for some time to “counter the factors that were restraining economic growth, including the slide in housing activity and prices, the tightening in credit availability, and the drop in equity prices." Fed fund futures continue to price in a 94 percent chance that interest rates will be cut by another 50bp in March. Although it is too soon to be worried about this, it is important to not forget the Fed’s warning today that should the economy stabilize and prospects for growth improve, a “rapid reversal” of a portion of the previous easing actions may be appropriate. Housing starts rebounded but building permits fell another 3 percent to the lowest level in 16 years. Leading indicators, jobless claims and the Philly Fed survey are due for release tomorrow. We expect the dollar to continue to remain weak because consumer prices was the only release this week that had the potential to trigger a reversal in the US dollar and unfortunately the impact was minimal.

British Pound Tanks As BoE Minutes Reveal Unanimous Support for a Rate Cut
So far this week, one of the best trades in currency market has been to sell British pounds. The nationalization of Northern Rock as well as the surprisingly dovish minutes from the Bank of England’s latest monetary policy meeting has pushed the GBP/USD within 50 pips of its 12 month low. Last week, the Bank of England released a relatively hawkish Quarterly Inflation Report, where they warned that inflation could breach the government’s 3 percent limit this year. This led many people to believe that the decision to cut interest rates earlier this month would meet resistance. However to the market’s surprise, not only did every single member of the MPC vote in favor of cutting interest rates, Blanchflower actually voted to cut rates by 50bp instead of 25. According to MPC member Barker, the slowdown in the economy is more worrisome than rising inflation. Another 50bp of easing has already been priced into the futures market and there is a decent chance that rates will fall to 4.25 percent before the BoE is done. Retail sales are due for release tomorrow and we expect the strength of the labor market to drive up spending.

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

Warnings from the ECB Weigh on Euro

With every passing day, the European Central Bank is slowly shifting its tone. Earlier this month, ECB President Trichet acknowledged that there are downside risks to growth which basically means that the Eurozone will no longer be immune to the US slowdown. ECB member Garganas went one step further today by saying that the credit markets could have a bigger impact on Eurozone growth than initially anticipated which completely offset the fastest pace of growth in German producer prices in 13 months. Germany is facing the same pressure of higher food and energy prices as the rest of the world which is the main reason why the ECB won’t cut interest rates until they have no other options. We expect a rate cut to come in the second half the year, which should lead to a reversal in the EUR/USD, but before that we should see a push above 1.48 and a possible test of the all time high. Eurozone consumer prices, the Swiss trade balance and Swiss Producer prices are due for release tomorrow – expect another active trading session.

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

Australian Dollar Hits 3 Month High, Canadian Dollar Rebounds
While the British pound has been one of the best currencies to sell this week, the Australian dollar has been one of the best currencies to buy. The currency hit a 3 month high against the US dollar today as the market continues to absorb the Reserve Bank of Australia’s surprisingly hawkish monetary policy. The Canadian dollar on the other hand rebounded thanks to stronger economic data and higher oil prices. Both leading indicators and Canada’s international securities transactions beat expectations while oil futures hit an intraday high above $101 a barrel. We continue to be bullish Australian dollars and expect it to test its year to date highs against the US dollar.

Tell us what you think about the loonie on the Canadian dollar Forum.

Carry Trades Make a U Turn

Last night, news that private equity firm KKR warned that they will be delaying repayments for a second time, triggered a wave of carry trade selling. That move was reversed in the NY trading session when the Dow went from being down over 100 points to up 90. Although this could lead to some follow through strength in the Yen crosses, we remain bearish because this type of volatility in the financial markets is more negative than positive for carry trades. The Japanese remain concerned about growth which suggests continued weakness in data.

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


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