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Is this Only a Temporary Bounce For Carry Trades?

- US Dollar to Remain Weak as Fed Prepares for Another 50bp Cut on Jan 30 - Is this Only a Temporary Bounce For Carry Trades? - Bank of Canada Cut Interest Rates 25bp, More to Come

DailyFX Fundamentals 01-22-08

By Kathy Lien, Chief Strategist of DailyFX.com

US Dollar to Remain Weak as Fed Prepares for another 50bp Cut on Jan 30

The volatility in the financial markets caused panic at the Federal Reserve, resulting in the first intermeeting rate cut since 2001. Before the US stock markets opened, Bernanke slashed the Fed Funds rates by 75bp, the largest cut in 23 years. With Dow futures falling 500 points on Monday, the Fed refused to sit back and watch the US stock index plunge another 4 or 5 percent. They knew that they needed to act quickly and significantly to prevent US equities from wiping out billions of dollars off the value of publicly traded US companies. Did it work? Yes and no. The Dow did not fall 500 points, but it still ended the day down 128 points. Although the Fed’s 75bp emergency cut indicates how serious they are about averting a deeper slowdown in US growth, it is not enough. According to the statement that accompanied the move, the Fed’s primary concern was increasing downside risks to growth, a deepening housing contraction and softening labor markets (more details on the Fed’s Emergency Rate Cut). Since appreciable downside risks to growth remain, they stand ready to act in a timely manner. In other words, their game plan is to continue to lower interest rates. Fed fund futures are pricing in a 100 percent chance that another move will be made at the end of the month with the highest probability action being another 50bp rate cut. The announcement has driven the US dollar lower against every major currency except of the Japanese Yen which has benefitted from a general rally in carry trades. With this move, the US dollar is now the third lowest yielding currency in the developed world. US rates are now 50bp less than Eurozone and Canadian Rates, 200bp less than UK rates and 325bp less than Australian interest rates. The futures curve suggest that we could see another 100bp of easing by the end of the year, which means that the US dollar is quickly become a carry trade funding currency. A little more than 5 months ago, US interest rates were the fourth highest in the developed world and now it is the third lowest. It is realistic to expect a return to 1.00 percent interest rates because the problems that the US economy faces now are more severe than the problems it faced when the tech bubble burst. The combination of falling equity prices and falling interest rates was the same dynamic that sent the US dollar plunging against the Japanese Yen between 2002 and 2005. The US dollar started its downtrend in middle of 2007 and we believe that this move will take USD/JPY back towards 105 and the EUR/USD to 1.50.

Is this Only a Temporary Bounce For Carry Trades?

The Federal Reserve’s emergency rate cut has helped carry trades rebound across the board. The question now is whether those gains can be sustained. Judging from the price action of many of the Yen crosses, further gains may be difficult since the rallies in USD/JPY, EUR/JPY and GBP/JPY have all stopped short of yesterday’s high. How Asian stocks behave will be the key to determining if the gains will last. Asian stocks have sold off aggressively over the past 2 trading days and if there was a catalyst strong enough to drive a recovery, it would the Fed’s surprise interest rate cut. The overall market environment is still not favorable for carry trades with the markets still risk averse, volatility remaining high and central banks around the world embarking on a global easing cycle. Even though the Bank of Japan kept interest rates unchanged at 0.50 percent last night and warned that the next move on rates would be up, we expect them to leave interest rates at the same level for the remainder of the year. One key point that is worth paying attention to is the comment from Finance Minister Nukaga who said that the government is not thinking of large scale forex intervention. As USD/JPY neared 105, many traders questioned whether the BoJ would step into the markets to artificially push down the value of the Yen and according to Nukuga, they won’t.

Bank of Canada Cut Interest Rates 25bp, More to Come

The Bank of Canada cut interest rates by 25bp to 4.00 percent and warned of more rate cuts to come despite much stronger than expected retail sales. According to the BoC statement, the risks to inflation were roughly balanced, but the risk to growth is skewed to the downside. Therefore further “monetary stimulus is likely to be required in the near term.” We expect at least another 50 to 75bp of easing this year. Consumer spending is holding steady, but Canada is no longer immune to the slowdown in US growth which is why the USD/CAD rally may not be over. Australia will be reporting consumer prices this evening. The slowdown in producer price growth suggests that consumer price pressures could ease as well. With relatively decent fundamentals, we expect the Australian dollar to outperform the US dollar in the coming weeks.

Euro Headed Back Towards 1.50? British Pound Vulnerable Ahead of BoE Minutes

The Euro has rallied thanks completely to the surprise rate cut from the Federal Reserve since comments from ECB officials are growing less hawkish by the minute. Constancio said this morning that the chance of a US recession has increased and as a result, he sees revised expectations for European growth. Junker echoed the same message when he said that Europe no longer rules out a US recession. Although we do not expect the Eurozone to be immune from the rapid deterioration in the US economy, we also do not expect the European Central Bank to cut interest rates. As a result, the increasingly lower rates offered by the US and the steady rates offered by the Eurozone should send the Euro back towards 1.50 Meanwhile the British pound has also rallied, but traders should watch out for tomorrow’s GDP numbers and the release of the minutes from the most recent central bank meeting. If you recall, the BoE left rates unchanged. A narrow margin would be perceived as pound bearish while a strong majority in favor of unchanged rates would be positive for the British pound. Finally, Switzerland reported weaker than expected retail sales growth, but that has had little impact on the Swissie.