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Euro Within 1 Penny of its Record Highs

- Fannie and Freddie's Troubles are a Lose-Lose for the US Dollar - British Pound: Time for Some Action

DailyFX Fundamentals 07-11-08

By Kathy Lien, Chief Strategist of DailyFX.com

Fannie and Freddie’s troubles are a lose-lose for the US Dollar

Calling the financial markets active today is practically an understatement.

The combination of soaring oil prices and problems with Fannie Mae and Freddie Mac triggered sharp volatility in the equity and currency market.

At one point during the US trading session, the Dow jumped 200 points within minutes, driving EUR/JPY to a record high.

The market was initially very disappointed by US Treasury Secretary Paulson’s reluctance to bailout Fannie Mae and Freddie Mac, but they were pleasantly surprised by Bernanke’s offer to access the discount window (The ABCs of Fannie Mae and Freddie Mac’s Problems).

However their optimism was short-lived as stocks resumed their slide.

The biggest question in the financial markets right now is whether or not Fannie and Freddie are too big to fail?

If the government stepped in to prevent the Bear Stearns meltdown from crushing the market, they will undoubtedly step in to prevent a collapse in Fannie Mae or Freddie Mac because if either GSE fails, Americans will have to shoulder the burden.

Fed Chairman Ben Bernanke has already announced that the GSEs can have access to the discount window, which would allow them to borrow money directly from the Federal Reserve rather than the markets.

If Fannie and Freddie’s problems are not solved and they still have difficulties borrowing, this means that they will have difficulties lending, which is something that the US government cannot risk at this moment.

For the currency market, it is a lose-lose situation for the US dollar.

Further problems at Fannie and Freddie would push stocks lower once again, which would trigger another flight to safety out of US dollars.

A bailout would essentially double the public debt, risking a downgrade in the US credit rating.

Expect Friday’s volatility to continue into the new trading week. We have a very busy US economic calendar that includes retail sales, producer prices, consumer prices, the Empire State and Philly Fed manufacturing surveys, industrial production, the Treasury International Capital flow report, housing starts and the minutes from the last FOMC meeting.

Meanwhile the trade balance was stronger than the market expected thanks to a rebound in exports. Consumer confidence also improved modestly but it still remains near a 30 year low.

Euro within one penny of record highs

The Euro traded within one penny of its record highs on fresh fears that another major financial crisis may be around the corner.

If it wasn’t for the potential repeat of the Bear Stearns debacle in March, we would have a quiet summer.

However US stocks fell to a new 23 month low today triggering another flight to safety into anything but US dollars.

Whether the EUR/USD manages to hit a new record high will be less dependent on economic data and more dependent on how much better or worse the market feels about the health of Fannie Mae and Freddie Mac.

The latest rally in the Euro helps Eurozone nations deal with the rise in oil prices but it also raises the risk of sharply weaker growth for countries other than Spain and Ireland.

Like the US, there are a number of pieces of economic data on the Eurozone calendar that are worth watching. This includes the German ZEW survey of analyst sentiment, consumer and producer prices.

Pound Sterling: Time for some action

The British pound strengthened against the US dollar due entirely to dollar weakness.

Although the problems with Fannie Mae and Freddie Mac affect the US the most, the UK will not escape unscarred.

Bond yields have started to trickle higher while the FTSE has plunged alongside the Dow.

In some ways, the UK economy is in as much trouble as the US. According to the latest data from mortgage lender Halifax, house prices dropped for the fourth month in a row to the lowest level on record.

More housing market data will be released next week and we do not expect the current trend to change. The UK will be reporting consumer and producer price growth along with their employment numbers for the month of June.

Inflationary pressures are expected to grow, but the outlook for the unemployment numbers are mixed. Even though the labour conditions in the service sector improved last month, conditions in the manufacturing sector deteriorated.

Big week ahead for the Canadian and New Zealand Dollars

Of the three commodity producing currencies, the Australian dollar was the market’s biggest focus this past week.

Not only were employment numbers released, but currency pair soared to a new 25 year high this morning.

A move above the August 1982 high of 0.9905 would mark a 26 year high for the currency.

Next week, the currency market’s focus will shift to the Canadian and New Zealand dollars. The Bank of Canada has a monetary policy decision. Although they are not expected to alter interest rates, watch out for any market moving comments from the BoC Governor.

New Zealand on the other hand has retail sales, service sector PMI, and consumer prices due for release.

Given the sharp drop in consumer and business confidence, we expect the data to be kiwi bearish. The divergence in economic activity between Australia and New Zealand has driven the exchange rate of AUD/NZD to a new seven year high.

EUR/JPY hits record high

Japanese Yen crosses have had a varied reaction to the volatility in the Dow today.

USD/JPY and CAD/JPY came under aggressive selling pressure, while EUR/JPY and CHF/JPY are higher. This tells us that traders are just selling US dollars and not all risky assets.

Depending on which Yen crosses that you buy, the carry trade could still be working. EUR/JPY hit a new record high, which is a trend that we have seen often.

When the Dow first broke the Bear Stearns low in late June, EUR/JPY also rallied to a new high. Looking ahead, the Bank of Japan is expected to leave interest rates unchanged at 0.5% as the economy continues to suffer.