Is It Time for the ECB to Start Buying Dollars?

DailyFX Fundamentals 03-17-08

By Kathy Lien, Chief Strategist of DailyFX.com

Why the Fed Needs to Cut More Than 100bp

Last week, we warned that the Federal Reserve is on high alert and now, we understand why. Pandemonium has hit the financial markets as the US dollar trades below parity against the Swiss Franc for the first time ever, hits a record low against the Euro and a 12 year low against the Japanese Yen. Bear Stearns' demise has sent shockwaves across Wall Street and everyone is holding their breath for the next shoe to drop. After surprising the markets with a 25bp discount rate cut on Sunday and extending the discount rate window to investment banks, the Federal Reserve is set to make another historic move by cutting interest rates 100bp tomorrow. This would be the first time in over 23 years that the central bank has cut interest rates by more than 75bp during the single meeting, reflecting the severity of the current US economic situation. In reaction to the Fed's move, the Bank of England and the Bank of Japan have also injected liquidity but the Fed's efforts have been futile thus far as banks refuse to take on more counterparty risk. Bond yields are also down significantly. The 3 month t-bill rate fell to the lowest level in over 50 years while the 2 year treasury bond yield fell to the lowest level in 5 years. This tells us that the Federal Reserve will need to cut interest rates by more than 100bp. In fact futures traders already expect rates to come down to 1.25 percent by the end of June. However, if Bernanke really wants to reassure the financial markets, he should cut by 125bp tomorrow and come up with more creative ways to prevent another liquidity crisis. We say no more band-aids Bernanke, please give us a real solution. Could the Federal Reserve cut interest rates by 75bp tomorrow? Yes, but as much as the market fears that another bank on Wall Street will collapse, Bernanke fears the consequences of under delivering. Unless he wants to cause the stock market to fall by another 300 points, he will cut interest rates by 100bp and the FOMC statement will remain dovish. The need for further monetary easing and the uncertainty in the financial markets will continue to drive the US dollar lower, particularly against the Japanese Yen. Expect 200 to 300 pip days in the majors to become the norm. Economic data remains weak with the Empire manufacturing survey plunging to a record low and industrial production dropping by 0.5 percent. The current account deficit narrowed but the total net Treasury International Capital flow fell far short of expectations. Before the FOMC rate decision tomorrow afternoon, producer prices will be released.

Is It Time for the ECB to Start Buying Dollars?

Even though the EURUSD rose to a high of 1.5904 intraday, don't expect the European Central Bank to intervene in the Euro anytime soon. They have said that they are concerned or worried about sharp and excessive moves, but until the EUR/USD breaks 1.60, we do not anticipate verbal let alone physical intervention. In 2004, the EUR/USD rallied 13 percent in 2 months before the ECB called the move brutal. If we count 1.59 as the high today, the EUR/USD has only appreciated 10 percent over the last 2 months. The ECB's top priority is inflation and for the time being, they are not going to back away from their commitment to maintain price stability because the strong Euro is cushioning the pain of high commodity prices. It is also important to mention that on a day when the Fed, BoE and ECB pumped liquidity into the financial system, the ECB is sitting on the sidelines. We would not be surprised if they made a similar move over the next few days, but the fact that they avoided doing so indicates that they are not willing to solve someone's else's problems at the risk of their own.

Carry Trades Will Continue to Suffer

USD/JPY fell to the lowest level since September 1995 and we expect the currency pair to continue to weaken. Risk aversion and volatility is the main theme across the financial markets and for that reason carry trades should continue to suffer. We have often said that three conditions need to be met for carry trades to thrive (low volatility, strong risk appetite and global monetary tightening) and unfortunately, the current market environment is veering further and further away from that description. Like the ECB, it is unlikely that the BoJ will step in to stop the USD/JPY's slide before it falls below 95. The Japanese have expressed concerns about disorderly movements, but since their last intervention in 2004, their top priority has been to convince China to revalue their currency. They are not likely to be willing to risk the past 4 year's efforts 3 weeks before the finance minister's meeting in Washington DC and 4 months before the G7 meeting in Japan.

Drop in Oil Prices Drive Canadian, Australian and New Zealand Dollars Lower

The Canadian, Australian and New Zealand dollars have fallen under the weight of lower oil prices, steady gold prices and risk aversion. New Zealand and Canadian economic data were actually stronger than expected with service sector PMI in New Zealand rising from 51.9 to 55.5 and Canadian new motor vehicle sales and manufacturing shipments both increasing strongly. Tomorrow we have Canadian consumer prices. We expect CPI to be hot given the rise in industrial product prices and raw material prices. However where the commodity currencies go is really a matter of whether risk aversion exacerbates over the next 24 hours.

British Pound Hits Record Low

The British pound fell to a record low against the Euro as the market punishes the currency for being a measure of risk. The sterling actually sold off against everything in sight including the US dollar, Japanese Yen and Swiss franc. There was no UK economic data released last night, but consumer prices are due for release tomorrow. They are expected to be strong given the rise in BRC shop prices and producer prices. However that will not matter for the pound if risk aversion dominates the currency market once again.