Euro: Modest Downside Risk (page 1 of 2)

DailyFX Fundamentals 11-29-07

By Kathy Lien, Chief Strategist of DailyFX.com

Could the Federal Reserve Cut by 50bp?

The US dollar has rebounded but don't be fooled into thinking that this is a bottom because if anything, US fundamentals continue to point to further dollar weakness. This morning's economic data was horrid. Not only was October new home sales smaller than expected, but sales in September were revised down to an 11 year low. Third quarter GDP was right in line with expectations but the report does not reflect the slowdown in growth that we have seen over the past 2 months. Jobless claims also jumped to the highest level since February. As a result, rate cut expectations have skyrocketed. The futures market is now pricing in a 100 percent chance of a quarter point rate cut in December and a 26 percent chance for a half point cut. Although we think that a half point cut would be too severe, we do not expect the next interest rate cut by the Fed to be their last. LIBOR rates are rising around the world and this will pressure central banks to ease monetary policy. We have already seen liquidity injections by the Fed and the ECB, but they should only be a temporary solution. However with that in mind, the dollar could rally in the short term if tomorrow's personal income and spending gap narrows or Chicago PMI increases as we expect. Rather than buy the dollar for a near term bounce, the better trade may be to look for an opportunity to sell on a bounce.

Euro: Modest Downside Risk

The failure of equities to extend their gains in a meaningful way has weighed on all high yielding currencies including the Euro. With mixed economic data, we attribute today's weakness to a broad base dollar recovery and to carry trades including EURJPY giving back some of the sharp gains that it has incurred over the past 2 trading days. With regards to economic data, German unemployment was much better than expected but French retail PMI was weaker. Spending is contracting despite steady employment which is worrisome and could lead to further downside risk. However we believe that the outlook for the Euro in the near future will be more dependent upon US fundamentals over Eurozone fundamentals because the pace of deterioration in the US will probably be sharper than the deterioration in Europe. German retail sales, Eurozone CPI and GDP are due for release tomorrow. Higher inflation is pretty much a given but the retail sales is a tough call because the improving labor market supports stronger spending but retail PMI suggests otherwise. Meanwhile Swiss GDP is also due for release. The strength of the KoF as well as the prior weakness of the Franc puts the odds in favor of stronger growth in the third quarter.

Bank of England Offers Emergency Funds

The British pound has sold off sharply against the Euro and we think that today's weakness will continue. Mortgage approvals were much lower than expected and Nationwide house prices fell by the fastest pace in 12 years. The housing market is suffering which is expected to translate into weaker consumer confidence. The GFK report is due for release tomorrow and the odds are in favor of pound bearish numbers. The Bank of England also announced that they will be offering emergency funds with longer repayment terms in reaction to the sharp rise in LIBOR rates. The credit markets must be very tight if the BoE who failed to act in August felt compelled to offering funding now. The only piece of good news was the CBI distributive trade survey which increased unexpectedly.