Bank of Canada to Leave Rates Unchanged, but Watch Out for Surprisesw

DailyFX Fundamentals 10-15-07

By Kathy Lien, Chief Strategist of DailyFX.com

Black Monday Haunts the Currency Market

On the twentieth anniversary of Black Monday, everyone has drawn comparisons between the 1987 crash and present market conditions. The conclusions drawn by most are that conditions are worse now than they were 20 years ago. Although we think that the comparison is not entirely accurate because many factors have changed over the past two decades, it is always interesting to do our own retrospective of how currencies traded in October 1987. Twenty years ago, the stock market suffered its largest one day percentage decline of 22.6 percent. During that month, the US dollar fell close to 1000 pips against Japanese Yen, 1000 pips against the British pound, 600 pips against the Australian dollar and 400 pips against the Euro. Even though carry trades and high yielding currencies were not as popular then as they are now, we can still see that the drop in the Dow led to a rise in risk aversion and a massive exodus out of US dollars. Although Black Monday could be haunting the financial markets once again, today's rise in risk aversion and sell-off in stocks have been triggered by weak earnings from Citigroup, a sharp rise in oil prices and news that the nation's three largest banks will be creating a rescue fund to help bail out the troubled global credit markets. With inflationary pressures on the rise and credit markets continuing to find stability, it will be very difficult for the Federal Reserve to lower interest rates again this month. Expectations for a rate cut remain at 32 percent, which is unchanged from Friday. This indicates that today's move is mainly due to concern about earnings rather than concerns about inflation. The Empire State manufacturing survey was much stronger than expected this month thanks to the weakness of the US dollar. Fed Chairman Bernanke is speaking on the economic outlook this evening, so watch out for any market moving comments. Tomorrow we have the Treasury International Capital flow report, industrial production, and the NAHB housing market index. It will not be a surprise if the housing market is weak and industrial production is stronger, but foreign inflows could suffer as a result of the credit crunch in August.

Bank of Canada Expected to Leave Rates Unchanged, but Watch Out for Surprises

Canadian dollar traders should watch out for surprises when the Bank of Canada announces their interest rate decision tomorrow morning. Interest rates are expected to be left unchanged at 4.5 percent, but some traders are gearing up for a surprise rate hike or hawkish comments from the Bank of Canada. The labor market is tight and most economic data has been firm including this morning's leading indicators report. Although the strong Canadian dollar is expected to reduce inflationary pressures, this dynamic could be offset by stronger wage pressure. We continue to believe that the Bank of Canada will be very cautious about saying anything that could strengthen the Canadian dollar even further, but we acknowledge the fact that the economy is strong. Oil prices also closed at a new record high above $86 a barrel. It may just be a matter of time before the Canadian dollar reacts. Gold prices are also higher, but the Australian dollar has given back its earlier gains on the back of the reversal in the stock market. It has outperformed the New Zealand dollar, which suffered from weaker than expected inflationary pressures. Instead of rising, annualized consumer price growth dropped from 2 to 1.8 percent.

Euro: Will Weak Confidence Cripple the Euro?

Even though the Euro is hovering less than 1 Euro-cent away from its all time high, the currency is struggling to extend its gains. ECB President Trichet continues to talk more about the Japanese Yen and Chinese Yuan than the Euro, which leads everyone to believe that he is still very comfortable with the way the currency is trading. The latest rise in oil prices will only exacerbate his concerns about inflation which is the primary reason why the central bank has been so hawkish. The question ahead of us however is whether inflationary pressures will offset a drop in analyst sentiment. Eurozone consumer prices for the month of September are due for release tomorrow along with the German ZEW survey. Analysts are typically far more pessimistic than businesses. In recent months, their degree of pessimism has not been useful in determining where the Euro is headed. Aside from the Eurozone data, Switzerland will also be releasing their retail sales report for the month of August. Consumer spending is expected to be firm, but that may help the Swiss Franc recover much of its losses since last week's comments from SNB President Roth was pretty bearish for the Swissie.

British Pound Rallies as House Prices Rebound in October

The British pound is stronger today thanks to the rebound in house prices this month reported by online property listing site Rightmove. This may be important, but not as important to British pound traders as tomorrow's UK consumer price report. The strength of the British pound last month should reduce inflationary pressure significantly. If a drop materializes, there will be less pressure on the Bank of England to raise interest rates. If commodity prices dominate however, we could see a sharp break to the upside in the GBP/USD. The currency pair is pressing against the top of its month to date range and looks prime for a breakout.

Carry Trades Hit by Equity Market Weakness

On Friday, we said that the number one thing that Japanese Yen traders should focus on is the Dow. Today's move proves that equities continue to dictate the market's appetite for carry. The sharp sell-off in the Dow reversed all of the earlier gains that carry trades and other high yielding currencies incurred during the early European trading session. The market will continue to ignore tonight's reports on tertiary activity and leading indicators. A rebound in the Dow will determine whether we see a rebound in carry.