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FX Research - Currency Markets Gear Up For Another Rate Cut

Wednesday, 21 November 2007 20:27:19 GMT

Written by Kathy Lien, Chief Currency Strategist

• Euro Hits New Record High
• British Pound Falls to 4 Year Low Against Euro

Currency Markets Gear Up For Another Rate Cut

The price action in the financial markets today reminds us of the price action that we saw back in August when the Federal Reserve shocked the markets by lowering the discount rate. Surprisingly, our wave déjà vu comes not from the sharp drop in carry trades but from the sharp moves in the bond market. Two year bond yields fell below 3 percent to the lowest level in close to 3 years. The five year TIPS yield, which is the spread between Treasury Inflation Protected Securities and the Treasury Bond Yield, fell to the lowest level in 2 years. This indicates that investors are rushing into inflation protected assets that carry no credit risk because their concerns about the US economy are growing. Part of that concern stemmed from Treasury Secretary Paulson’s warning last night that home loan defaults in 2008 should be substantially greater than the defaults in 2007. Today’s economic data confirms the trouble. Mortgage applications and leading indicators were both weaker than expected and even though jobless claims and the University of Michigan consumer confidence number were better than the prior period, they remain at levels consistent with weaker growth. With oil prices closing in on $100 a barrel, consumer spending could be particularly bad this holiday season. The prospect of more difficult times ahead has traders pricing in a 100 percent chance of a quarter point rate cut next month and a slim chance of a 50bp cut. Half a point would be too much too fast for the Federal Reserve so this option is basically obsolete. Meanwhile trying to figure out whether the US dollar will continue to weaken is not a difficult task. The US is the only major central bank actually lowering interest rates while everyone else is either on hold or raising them. Until another country begins to lower rates as well, the dollar’s weakness could continue; our target is still 1.50 for the EURUSD. US markets are closed for the Thanksgiving holiday on Thursday. The next release Daily Fundamentals will be on Friday.

Euro Hits New Record High

The price action of the EURUSD over the past 3 months is a perfect example of why fighting the trend is far more difficult than joining it. Since the middle of August, the currency pair has appreciated 11 percent. The hawkishness of the ECB and the remarkable resilience of the Eurozone economy have contrasted sharply to the increasingly dovish bias of the Federal Reserve and deterioration in the US economy. Looking ahead, there is no immediate threat to further EURUSD gains. It is no secret that currencies are usually trending in nature and unless there is a reason for this trend to change, it probably will not. Even though the US markets are closed tomorrow, there are plenty of Eurozone economic data due for release. This includes the final third quarter GDP figures, the current account balance and industrial orders for the month of September. Unfortunately don’t expect these numbers to be very market moving. According to our 10 year analysis of EUR/USD price patterns on Thanksgiving, the average daily range is approximately 60 percent of the usual daily range for the currency pair. More specifically, the EURUSD has had an average daily range of 102 pips over the past 10 years, but on Thanksgiving Day, the average daily range is only 61 pips.

British Pound Falls to 4 Year Low Against Euro

The British pound fell to a four year low against the Euro following evidence that the Bank of England could seriously lower interest rates next quarter. According to the minutes from the last monetary policy meeting, even though the BoE left interest rates unchanged, two out of the nine members voted in favor of lowering rates. Gieve and Blanchflower were worried that more bad news may come as the money markets tighten further. Their prophecy seems to be already unfolding with today’s reports that UK mortgage lender Paragon could be collapsing if it fails to raise an extra GBP280 million. The UK economy has still not recovered from the Northern Rock debacle which led to the first run on a UK bank in more than 100 years. The market now expects the BoE’s next move to be a rate cut. Third quarter UK GDP is due for release tomorrow; the annualized pace of growth is expected to be 3.3 percent.

Australian, New Zealand and Canadian Dollars Test Bottom of Week Long Range

On a day to day basis, we have seen big moves in the Australian, New Zealand and Canadian dollars this week. However even though the daily trading range is large, if you take a step back, these three currencies are basically stuck within a wider range against the US dollar. They are now testing the bottom of that range which suggests that a breakdown may be possible. Although weaker economic data can be blamed for the CAD’s turn back towards parity, Australian and New Zealand data have been decent and commodity prices have been holding up well. This means that the latest wave of weakness has been spurred by nothing other than risk aversion,

Japanese Yen Hits 2 Year High Against the Dollar

The Japanese Yen rose to a 2 year high against the US dollar as the stock market extended its weakness by another 200 points leaving carry trade liquidation the biggest story in the currency market. Volatility is back on the rise which is never good for carry trades. It has been difficult for carry traders to keep up with the triple digit swings in the stock market. What we know for sure however is that according to the bond market, traders are definitely become more risk averse and if that continues, so will carry trade weakness. USDJPY looks vulnerable to further losses after making a new two year low. Despite the prior weakness of the Japanese Yen, both the trade surplus and all industry activity index was worse than expected but that did not stop the Yen from strengthening.

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By Kathy Lien, Chief Strategist of DailyFX.com


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