Euro Hits Record Highs: Is 1.40 Next?

DailyFX Fundamentals 09-18-07

By Kathy Lien, Chief Strategist of DailyFX.com

Federal Reserve Put Drives US Dollar to Record Lows

The Greenspan put has now become the Bernanke put. This term was coined back in 1998 when then Federal Reserve Chairman Alan Greenspan bailed out the financial markets by lowering interest rates after the collapse of Long Term Capital.

Today, current Chairman Ben Bernanke gave the markets the biggest confidence boost that traders could have hoped for by cutting both the Fed funds rate and the discount rate 50bp.

By not committing to any future policy moves, the statement also left the door open for further interest rate cuts leading Fed Fund futures to now price in another 50bp of easing before the end of the year. The decision was unanimous which makes it even more significant since every one of the FOMC members seemed to believe that the risks to growth far outweigh the risks to inflation.

With this move, no one can say that the Federal Reserve is behind the curve. The rate decision has sent the US dollar tumbling to a new record low against the euro and a fresh 30 year low against the Canadian dollar. The only currency that the US dollar strengthened against is the Japanese yen which benefited from the 335 point rally in the Dow.

A new trend has been established after Fed rate decision and we expect to see significant follow through not only in the Asian markets, but also in the US and European markets over the next few days since this will not be the one and only interest rate cut from the Federal Reserve.

As for what to watch next: keep an eye on consumer spending and non-farm payrolls. Even though today's step goes a long way in preventing a recession, it still does not rule out one. If we have two back to back months of negative retail sales or non-farm payrolls, traders will begin to question whether the Federal Reserve has done enough.

Meanwhile producer prices saw the biggest decline since October 2006 while the NAHB index dropped to a record low. These disappointments validate the need for easier monetary policy.

Tomorrow, we have consumer prices and housing starts. With both crude and gasoline prices both dropping significantly in August, the numbers should be tepid, especially since the new highs in oil were not made until September.

Euro Hits Record Highs: Is 1.40 Next?

The euro hit a record high of 1.3985 after the Federal Reserve's monetary policy decision. Even though there are a lot of option barriers at 1.40, a test of that level seems inevitable.

The monetary policies of the European Central Bank (ECB) and US Federal Reserve are growing further and further apart, which provides a fundamentally sound reason for the EUR/USD to continue to rally. However euro traders should be warned.

As an export dependent region, a strong euro will eventually take a bite out of growth. The German ZEW survey dropped from -6.9 to -18.1, reflecting a growing sense of concern amongst analysts and economists.

The Fed's decision to lower interest rates by 50bp will probably keep the European Central Bank on hold for the remainder of the year as well. Yet, as long as the ECB does not turn dovish or lower rates themselves, the Euro could continue to remain firm.

Carry Trades Break Higher As Dow Rallies 335 Points

Over the past few months, we have seen a very strong correlation between US equities and carry trades. Today, that correlation was in full force as carry trades broke higher on the back of the 335 point rally in the Dow.

Not only did US equities rise to the highest level since July 27, but they also saw the largest percentage move since 2003. Rate cuts are generally good for the stock market, which is why the response by carry traders has been so positive.

According to CNN Money, since 1945 the S&P 500 rallied seven out of 11 times in the six months after a rate cut. On average, the rally was in excess of 12 per cent. So far, the Dow has only rallied 2.5 per cent, which means that there could be more room to go.

Therefore if you believe that the Dow is headed higher then you also believe that carry trades will continue to rise. Meanwhile the Bank of Japan is expected to leave interest rates unchanged tonight; no surprises are expected there.

Canadian, Australian and New Zealand Dollars All See Strong Gains

The Canadian, Australian and New Zealand dollars all performed extremely well today on the back of rising commodity prices and resurgence in demand for high yielding currencies.

The Fed's move today has restored confidence in the financial markets and confidence translates into risk appetite or renewed demand for commodity currencies. Gold and oil prices are also sharply higher today, which has helped to take the Canadian dollar to a fresh 30 year high.

There is no stopping the CAD at this point; parity with the US dollar (which is an exchange rate of 1.0) is so close that a test of that price level seems inevitable.

Reserve Bank of Australia Governor Stevens was also on the wires last night downplaying the impact of the US economic slowdown on the Australian economy. Australia stands to benefit significantly from growth in Asia, which is expected to remain solid.

Yesterday, the Asian Development bank raised their growth forecasts for Asian economies excluding Japan from 7.3 to 8.3 per cent.

British Pound Back Above 2.0 Despite Softer Inflation Data

The Federal Reserve's rate decision has taken the British pound back above 2.0. US dollar weakness has overshadowed recent concerns about the UK economy.

Consumer prices were in line with expectations, with the exception of the annualised pace of CPI growth which was 1.8 per cent against 1.9 per cent expected.

The government's guarantee of Northern Rock's deposits has done nothing to stop depositors from withdrawing funds. The minutes from the last monetary policy meeting are due for release tomorrow, which will shed more light on the Bank of England's degree of concern about the economic impact of the credit market turmoil on the UK economy.