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Is the Euro the Dollar and Yen’s Puppet?

- Manufacturing Sector Slips into Recession, Is it Time for a 75bp Rate Cut? - Is the Euro the Dollar and Yen's Puppet? - British Pound Bounces, But Still Struggling to Sustain Gains

DailyFX Fundamentals 01-17-08

By Kathy Lien, Chief Strategist of DailyFX.com

Manufacturing Sector Slips into Recession, Is it Time for a 75bp Rate Cut?

In yesterday’s Daily Fundamentals, we warned that even though the US dollar recovered and we had a few pieces of stronger economic data, it is premature to assume that the sell-off has come to an end. Following the shockingly weak Philly Fed manufacturing survey, talk of a recession in the US economy is back in force and with lots of fundamental backing behind it. The manufacturing index fell to the lowest level in over 6 years which basically means that the manufacturing sector is already in a recession. Taken together with the Financial Times report that California and Florida are in or on the brink of a recession and we can understand why stocks fell over 300 points today. Housing starts dropped to the lowest level in 17 years while building permits posted their biggest drop in 33 years. The dollar is weaker against all of the major currencies with the exception of the commodity currencies and rate cut expectations have increased once again. Believe it or not the futures market is now pricing in a 58 percent chance of 75bp of easing at the end of the month up from 40 percent yesterday. In his Congressional Testimony, Bernanke repeated his prior warning that the Fed is “ready to take substantive additional action.” Up until today, this meant 50bp of easing because we expect the Federal Reserve to deliver exactly what the market prices in, nothing more, nothing less. Now that rate cut expectations are favoring 75bp of easing, we will be watching to see if those expectations grow. The financial markets have been extremely volatile and Fed fund futures are no different. We do believe that the US economy needs a 75bp rate cut, it is just a matter of whether Bernanke will risk a jump in inflationary pressures to support growth. If the Bush Administration announces a stimulus package, that too could lower rate cut expectations as tax cuts and additional spending reduces the need for more aggressive easing. Leading indicators and the University of Michigan consumer confidence reports are due for release tomorrow; both numbers are expected to be dollar negative.

Is the Euro the Dollar and Yen’s Puppet?

The Euro ended the day unchanged against the US dollar as EUR/JPY selling grappled the markets. The Eurozone trade balance was narrower than expected due to a slowdown in import and export growth. There is no doubt that the Eurozone economy is becoming less immune to the slowdown in the US or globally for that matter, but the problems across the pond (in the US) is still more severe. Also, despite ECB member Mersch’s shift from hawkish to dovish yesterday, other members of the ECB remain hawkish. Today Liebscher said that the primary task for the central bank is to avert second-round inflation. Although their stubbornly hawkish stance should keep the Euro from falling severely, there are consequences. Airbus warned that orders for their aircrafts could fall 50 percent this year and even though they did not directly cite the Euro, we are sure that the currency’s strength and the global slowdown are the primary reasons for the company’s dire forecasts. We doubt that Airbus is the only company suffering from a strong currency and slower export demand. Meanwhile, the Swiss Franc is weaker across the board as the Swiss Investor Confidence index falls for the third month in a row.

British Pound Bounces, But Still Struggling to Sustain Gains

The British pound strengthened against every major currency with the exception of the Japanese Yen. There was no economic data released from the UK and perhaps the lack of it is exactly what is helping the currency recover. Tomorrow however, the currency will be in play with retail sales due for release. The deterioration in the BRC retail sales monitor suggests that spending could slow, but the rise in average earnings including bonuses means that any slowdown may not be material. For traders who believe that the British pound has reached a bottom and will continue higher, the better bets may continue to be pairs like GBP/AUD and GBP/CAD because the one thing that has not stopped is carry trade liquidation. Having already sold off significantly, the British pound could outperform the Australian and Canadian dollars.

Australian, New Zealand and Canadian Dollars Extend Losses

The Australian labor market remains strong, but that has not helped to shield the Australian dollar from a sharp rise in risk aversion. 20k new jobs were created last month, driving the unemployment rate down to 4.3 percent, which is just shy of the 33 year low of 4.2 percent, reported in September. New Zealand consumer prices were also stronger than expected, remaining well above the central bank’s 3 percent target. Retail sales were hot, having risen 2.0 percent in the month of November, which was the strongest pace of growth since February. Economic data from both countries still favor tight monetary policy which is why we think that once the stock market stabilizes, the Australian and New Zealand dollars will be the first to rally. The outlook for Canada on the other hand is very different. Foreign purchases of Canadian securities fell for the seventh month in a row, supporting more weakness in the Canadian dollar.

Stocks Fall 300 Points, Triggering Sharp Losses in Carry Trades

Stocks fell 300 points today, taking carry trades down with it. In fact, it would be surprise if the Japanese Yen crosses did not collapse. Growing evidence of problems in the US economy has spurred a massive exodus out of stocks on the fear that earnings will only worsen. Risk aversion is on the rise and the only thing that can stop it is either a big stimulus package from the Bush Administration or an intermeeting rate cut from the Federal Reserve. Japanese economic data at this point has little consequence.