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British Pound Falls to 9 Month Low as Chance for Rate Cut Exceeds 60%

- Could US Interest Rates be at 2.50% by Year End? - British Pound Falls to 9 Month Low as Chance for Rate Cut Exceeds 60% - Will ECB President Trichet Disappoint?

DailyFX Fundamentals 01-09-2008

By Kathy Lien, Chief Strategist of DailyFX.com

Could US Interest Rates be at 2.50% by Year End?

The lack of economic data has given traders and economists the opportunity to think about how bad the US economy will fare in 2008. Since the disturbingly weak non-farm payrolls number released on Friday, there has no been economic data to confirm or deny that the US economy is headed for a recession. As a result, most traders have braced for the worst as rate cut expectations continued to edge higher. According to Fed fund futures, the probability that the Federal Reserve will lower interest rates by 50bp at the end of the month is now 74 percent compared to 68 percent yesterday and 24 percent a week ago. The current debate in the market is 25 versus 50, but lets take a look at what economists are expecting beyond the January meeting. Assuming the Fed cuts by only 25bp, we could see as much as 150bp of further easing. Goldman Sachs and BNP Paribas expect interest rates to be at 2.50 percent by the end of the year, while Merrill Lynch is calling for rates to hit 2 percent in early 2009. On the other side of the spectrum, RBS Greenwich and Bear Stearns only believe that another 25bp is needed before the easing cycle comes to an end. At DailyFX, expect another 75 to 100bp of further easing before the cycle is over and we believe that it is still premature to call for 50bp of easing without seeing how consumer spending and consumer prices fared in the month of December. These numbers are expected next week. Recent comments from Federal Reserve Presidents confirm our belief that the members of the US central bank have not made up their minds. This morning, Poole said that even though the economic outlook is uncertain, it is too soon to tell if housing troubles will push the US economy into recession. Jobless claims, wholesale inventories and chain store sales are due for release tomorrow – these numbers should not be market moving.

British Pound Falls to 9 Month Low as Chance for Rate Cut Exceeds 60 Percent

The central banks of the UK and Eurozone will be announcing interest rate decisions tomorrow. Usually the ECB meeting steals the limelight, but this month, all eyes are on the Bank of England’s announcement. Over the past few weeks, expectations for another interest rate cut in the UK have slowly ticked higher and now, the derivatives market is pricing in a 60 percent chance that interest rates will be reduced by 25bp tomorrow (this is based upon Credit Suisse’s index of probability). The majority of economists still expect the BoE to keep rates unchanged. The major disconnect between analysts and traders is the main reason why we expect a lot of volatility after the BoE rate decision, regardless of whether the central bank chooses to lower interest rates because someone will be surprised. If the BoE leaves rates unchanged, we expect the GBP/USD to rally. If they lower rates, expect 1.95 to be broken. We believe that there is a decent chance for a rate cut since the Bank of England is traditionally a very dynamic central bank that responds quickly to changes in their economy. Recent economic data has reinforced their fears that the economy is slowing and there seems to be no respite in the foreseeable future. As a country that is heavily dependent upon financial services, the deterioration in the sector has taken a massive toll on the overall economy. Also, inflationary pressures are not as heavy in the UK, which will give the central bank the flexibility to lower rates before its too late. Both consumer confidence and leading indicators deteriorated from the prior month. Ahead of the BoE interest rate decision we have the UK trade balance due for release. Given the big event risk a few hours later, the trade numbers should not have a major impact on the British pound.

Will ECB President Trichet Disappoint?

The European Central Bank is not expected to alter interest rates tomorrow, but the comments from ECB President Trichet should lead to some volatility in the Euro. The big question is: How close is he to raising interest rates? Inflation pressures continue to persist and the high level of oil prices is undoubtedly a concern for the central bank. Yet economic data is beginning to weaken. German retail sales dropped 1.3 percent in the month of November which was much weaker than the market expected while industrial production fell 0.9 percent. Consumer spending is important for any country and even if the German unemployment rate fell to a 6 year low, if consumers are not spending, there are no drivers for growth. The best option for Trichet is to keep his mouth shut, but of course he does not have that luxury. Instead, we expect him to repeat the comments that he made last month, which will unfortunately not satisfy Euro bulls.

Australian and New Zealand Dollars Rise but Canadian Dollar Continues to Slip

The Australian and New Zealand dollars rallied off of stronger economic data and steady commodity prices. Thanks to a healthy labor market, consumer spending increased by 0.8 percent in the month of November. This highlights the overall health of the Australian economy and gives the Reserve Bank of Australia more reason to raise interest rates in 2008. We expect the strength in the Australian dollar to continue on the back of tonight’s trade balance numbers. Export orders jumped in the month of November, pointing to a strong release. The Canadian dollar on the hand continued to suffer following weak housing starts. Since the end of 2007, the divergence between Australian and Canadian economic data has helped the AUD/CAD rally over 300 pips.

Carry Trades Rebound as Dow Climbs 146 Points

Carry trades recovered today as the Dow climbed 146 points. The stock market has been extremely volatile. At one point, the Dow was down over 80 points. It was not until the last 2 hours of trading that they reversed violently higher. Whether this rally will last remains to be seen as we are still a long way from recovering the losses that US equities and USDJPY have incurred since the beginning of the year.