Will the Fed Put a Stop to the Dollar Rally?

Daily Forex Fundamentals | Written by GFT | Oct 25 08 06:09 GMT |

TODAY'S BIGGEST PERCENTAGE MOVERS AUD/JPY (-838 pips or -11.18%) NZD/JPY (-596 pips or -10.19%) AUD/USD(-516 pips or -7.67%) THE STORIES IN THE CURRENCY MARKET USD: WILL THE FED PUT A STOP TO THE DOLLAR RALLY? EUR: EURO TESTS 1.25, EMERGING MARKETS TO SUFFER FROM DOLLAR STRENGTH GBP: SEES SHARP REVERSAL AFTER HAVING BEEN DOWN 1000 PIPS CAD: OIL PRICES BELOW $65 A BARREL AUD: HITS 5 YR LOW AGAINST USD, 8 YR LOW AGAINST JPY NZD: HITS 5 YR LOW JPY: YEN HITS 1995 HIGH, WILL THE BANK OF JAPAN INTERVENE? EXPECTATIONS FOR UPCOMING FED MEETINGS ** PERCENTAGES MAY NOT ADD UP TO 100% BECAUSE OF THE PROBABILITY OF LARGER OR SMALLER MOVES BEYOND THOSE SHOWN ON THIS TABLE WILL THE FED PUT A STOP TO THE DOLLAR RALLY? Contrary to the some people's belief, the US equities did not crash today. When S&P futures hit its limit down levels before the US markets opened and Dow futures dropped 5 percent, some media outlets were touting the possibility of circuit breakers kicking in; that would have meant an 1100 point decline in the Dow. Thankfully, it did not happen and even though the Dow fell 312 points today, it is off its lows. The type of moves that we have seen in the currency market today is typically what we see in a quarter or a half year. USD/JPY is down more than 3 percent, the NZD/USD is down 6.25 percent while the AUD/USD has declined 7.75 percent. The sell-off in the Japanese Yen crosses is even more severe with AUD/JPY falling more than 10 percent. On Thursday, we said that even though it may be very tempting to call a top in the dollar, especially against the Euro, in order for this EUR/USD rally to be real and for investors to be convinced to stop selling higher yielding currencies, we need to see stabilization in the financial markets and a return of confidence. Equities are driving currencies as everyone sells first and ask questions later. The trigger for the collapse today was concerns about corporate profitability. Sony issued a profit warning, Samsung reported a 44 percent decline in Q3 profits while Volvo reported a 37 percent decline. Investors are finally seeing how big of a toll the global slowdown is having on exports. With risk of a further decline in export demand, central banks around the world will have to act aggressively to prevent the global recession from turning into a global depression. Fed Fund Futures are Pricing in the Possibility of a 75bp Rate Cut The anticipated event risk next week is the Federal Reserve's interest rate decision. Going into the meeting, the market is now pricing in an 68 percent chance of a 50bp rate cut and an 32 percent chance of a 75bp rate cut. This indicates that the market believes 25bp will be the minimum that the Fed eases on Wednesday. We believe that a 75bp rate cut will be a too aggressive because it leaves the central bank with next to no room to cut interest rates in case things get worse – and they will. The 3 most realistic options are a 50bp rate cut, a 50bp coordinated easing along with other central banks and a 25bp rate cut. A coordinated easing will probably have the most significant impact on the financial markets and given the drop in oil prices and the deterioration in European economic data, the ECB and the BoE may not be opposed to this option. Although the Fed may have considered a 25bp rate cut earlier this week, they know that if they under deliver now, the consequences for the equity market could be severe. A larger interest rate cut could put a stop to the dollar's rally. Where are the Value Points for the Currency Market? In the Wed edition of the Daily Currency Focus we talked about how the dollar could rise another 5%. At that time, the EUR/USD was trading at 1.2829 and the GBP/USD at 1.6236. The GBP/USD has already hit the 5 percent target and at one point this morning it even became undervalued on a purchasing parity basis. Although the UK GDP report confirms that the country is headed for a recession and validates the weakness, we have seen a near term low in the currency pair. As for the EUR/USD on the other hand it has only dropped 2.9 percent. The EUR/USD does not become a value play until 1.15-1.20. Consumer Confidence, GDP, Chicago PMI and New Measures by the Treasury In addition to the FOMC interest rate decision, there are a handful of other US economic data worth watching in the coming week. This includes new home sales, consumer confidence, durable goods, third quarter GDP, personal income, personal spending and Chicago PMI. Also keep an eye out for any new announcements from the US Treasury in an effort to bolster investor confidence. Existing home sales increased 5.5 percent last month which was stronger than the market expected, but the median price of a house sold fell sharply. HOW MUCH HAVE FX RANGES EXPANDED IN 2007? We all know that the daily trading range of currencies have expanded, but by how much? Compared to 2007, the daily average trading range for the EUR/USD year to date has increased 195%. The average range for GBP/USD has increased 150% while the range for USD/JPY has expanded by 140%. Since the beginning of October, the ranges have exploded even further. The average trading range for the EUR/USD is now 300% greater than the range in 2007. Here is a table with a quick study that we ran on trading ranges: EURO TESTS 1.25, EMERGING MARKETS TO SUFFER FROM DOLLAR STRENGTH Any positive sentiment expressed in Thursday's trading has been all but extinguished as the Euro drops 335 pips - the currency even temporarily traded below 1.25 against the US dollar. The Eurozone had a wealth of numbers released today, including German Import prices, French and German PMI, and Italian Business and Consumer Confidence. Unsurprisingly, PMI reports show that the Manufacturing sector has weakened substantially. Italian business confidence was weak while surprisingly consumer confidence was strong. In addition, German Import prices fell to -1.0%. Next Monday, the Euro-zone will face the German IFO index and there is a decent chance that sentiment has weakened substantially as uncertainty and fear has taken its toll on the global economy. The latest round of dollar strength continues to push emerging market currencies lower. It has forced these countries to raise interest rates (Denmark hiked by 50bp), take loans from the IMF and to obtain swap lines with the ECB. Crippled by a weak currency and the risk of runs on their currency, emerging Europe will no longer be the engine of growth that everyone may have hoped for. YEN HITS 1995 HIGH, WILL THE BANK OF JAPAN INTERVENE? The Japanese yen strengthen across the board, reaching some unheard of gains against the dollar and carry trades. Today's USD/JPY trading is one for the history books, with the pair falling more than 700 pips intraday. Even though the currency pair ended down only 370 pips, volatility like this is worth mentioning. The sell-off was triggered by the extreme losses in global equity markets, with the Nikkei falling almost 10 percent. Any hopes of stabilizing volatility seem to be tossed out the window as investors become more fearful than ever. The VIX hit a new historical high today, reflecting the continued aim of risk aversion. These magnificent price movements in JPY are not the result of any strengthening fundamentals in the part of the Japanese economy. If you are wondering about Bank of Japan intervention, don't expect it to happen. As an export dependent nation, a strong currency is not in Japan's best interest. However unlike in the past where the BoJ has intervened when USD/JPY fell below 105 and 100, we may not see any action by the Japanese government this time around. The Prime Minister has already said that the rise in the yen is not always bad because it pushes down oil prices for Japan. If he is considering intervention, he would not mention this. Since the problems are inherent in the US and the Eurozone, intervening at this time would be counterproductive for Japan. The Japanese government will want to stand aside and allow the US and Eurozone governments to take their own measures to spur growth and not strengthen the dollar for short term relief. GBP/USD SEES SHARP REVERSAL AFTER HAVING BEEN DOWN 1000 PIPS Even though the British pound has ended the US trading session down 375 pips or 2.25 percent, it has had an impressive recovery. A few hours before the US market opened, the GBP/USD fell more than 1000 pips to a low of 1.5267. At that time, the GBP/USD went from overvalued on a purchasing power parity basis to undervalued. Third quarter growth contracted 0.5 percent, which was more than the market expected. This decline confirmed the central bank's warning that the country is in a recession. Candor has not been rewarded in the financial markets as King's comments sent the British pound tumbling close to 13 percent against the US dollar this week. There are no significant UK economic releases on the calendar in the coming week. We believe that after the sharp sell-off, the GBP/USD is now due for a recovery. It is Daylight Savings in Europe this weekend, so the difference between Eastern Time and GMT becomes +5. COMMODITY CURRENCIES RAVAGED BY RISK AVERSION Despite OPEC 1.5 million barrel production cut, oil prices have tumbled, taking the Canadian dollar down with it. Risk aversion is to blame as the dollar's strength drives higher yielding currencies and oil prices lower. Canadian consumer prices were stronger than expected, just like the price component of the IVEY PMI report had predicted. The Australian dollar was the worst hit of the 3 commodity currencies with the currency falling 7.7 percent against the US dollar and 11 percent against the Japanese Yen. The New Zealand dollar dropped close to 7 percent as well. In the coming week, there are not many releases expected from Australia or New Zealand. Canada only has the August GDP report due for release. Therefore the fate of the comm. Dollars will continue to be tied to the market's risk appetite. EUR/USD: Currency in Play on Monday EUR/USD will be the currency in play on Monday with Eurozone and US economic data due for release. We expect German IFO Business Climate Index at 5:00 am ET and US New Home Sales at 10:00 am ET. Trading today has seen EUR/USD falling more than 300 points, reaffirming its position in the Bollinger Band sell zone. In order to identify support, we are using Fibonacci retracements drawn from the lows of November 2005 to the highs of April 2008. Despite the large slide in prices, action did respect the support 78.6% retracement. Resistance will be the high of yesterday's rally located at 1.3000. Lying above this level price action will face significant hurdles as there is the one-standard deviation Bollinger band, the 10-period SMA, as well as the 61.8% retracement lying at 1.3305. Therefore we will define resistance as a range between 1.3000 and 1.3305. To make any convincing attempt at a rebound, EUR/USD must develop the momentum to break these levels. Kathy Lien http://www.gftforex.com DISCLAIMER: GFT refers to Global Futures & Forex, Ltd. and all of its divisions, branches and subsidiaries, including Global Forex Trading and GFT Global Markets UK Limited. GFT Global Markets UK Limited is authorized and regulated by the United Kingdom Financial Services Authority. Each investment product is offered only to and from jurisdictions where solicitation and sale are lawful. Trading of foreign exchange contracts, contracts for differences, derivatives and other investment products which are leveraged, can carry a high level of risk, and may not be suitable for all investors. It is possible to lose more than the initial investment. In Australia, GFT means Global Futures & Forex, Ltd. ARBN 103 508 461, AFS Licence 226625. A Product Disclosure Statement (PDS) is available at www.gft.com.au. 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