Bob's Currency Focus

Thursday Oct 4: 16:00

Euro
The euro has rebounded to 1.4140 having hit a low of 1.4066 as markets grappled with the meaning of the ECB policy statement Thursday. Traders are positioning themselves ahead of the critical US payroll report 12:30GMT Friday which is going to determine the dollar’s immediate fate and today’s price swings may only prove to be temporary. The euro also fell against sterling today, going as low as 0.6910 before bouncing back to 0.6925. The ECB look set to stay on hold for the remainder of they year and with Trichet iterating downside risks to euro economic growth in the medium term, the euro may well struggle to recapture the 1.42 level against the dollar unless we see a poor non-farm number from the US Friday. With carry trade appetite on the up, the euro could hit 1.65 against the yen today. EUR/CAD is the one cross that offers some medium term upside value, having hit a low of 1.4050 today.

GBP
Sterling firmed after the Bank of England kept rates unchanged. Halifax house index shows the first price decline this year and with expectations of a rate cut before the end of the year, the pound’s gains could prove to be short-lived. Expect caution ahead of tomorrow’s US nonfarm payroll number and GBP/USD should largely remain in the 2.03 to 2.0440 range between now and then. With no UK data for the remainder of the week, sterling’s immediate fate depends on US data and a strong payroll number could see cable fall back below 2.0250.

USD
The prospects for Friday’s payroll number took a knock when the weekly jobless claims figure rose by its highest level in 4 months Thursday. Expect whiplash moves in the currency between now and 12:30GMT Friday. A figure of over 120K Friday should see the dollar push the euro back below 1.40, while another disastrous number <40K will raise expectations of further rate cuts and the greenback should fall to a new record low against the euro and to 2.05 against sterling.

YEN
The Japanese currency is totally out of favour this week and even declines in global equities in the past 2 days has failed to spark a yen revival. There should be consolidation below 117 against the dollar ahead of Friday’s payroll report, where a negative number could lead to a sharp correction back down to 115. The ratio of longs to shorts was nearly 50:50 in the latest COTS report, so the yen does not have the same potential to move as sharply as it did back in August, if risk aversion levels were to rise later this week. However, given the weight of the carry trade this week, AUD/JPY and GBP/JPY could sell off significantly Friday, if a weak US payroll report leads to heightened concerns about the state of the US economy.

CAD
Still the most resilient currency on the market and the CAD has now closed better than parity against the US dollar for 4 consecutive days. The economic fundamentals for Canada remain sound and the first big test for the parity-beating currency will come in the shape of August’s employment data on Friday (11:00 GMT), which is released 1.5 hours ahead of the US payroll data. A strong Canada payroll number could send the USD/CAD to below US0.99, while a minus number will see the CAD fall sharply against its US counterpart, regardless of the outcome of the US employment report. The CAD is overbought on most of the crosses at the moment, with little value on offer, although CAD/JPY could scale 118 if both the Canadian and US data is good on Friday.

Central Bank Outlook: ECB & BoE

ECB: October 4
Members of the ECB’s monetary policy committee find themselves in an unenviable position with political pressure on the back of a rapidly rising euro, uncertainty about the euro zone economic outlook, credit market problems and rising euro zone inflation all in the mix, when the MPC sits down to deliberate on its monthly policy statement on October 4th. The only thing that seems certain is that the ECB will leave interest rates unchanged at 4% but markets will be listening closely to what the Bank’s President – Jean Claude Trichet has to say when he gives his press conference after the rate announcement. After the last meeting in September smart money was on one more rate hike before the end of the year, probably to come in December next. The ECB may still decide to signal such a likelihood this Thursday, in its pursuit of price stability (September is the first time inflation has risen above the ECB’s 2% comfort zone since August 2006 - a 2.1% preliminary inflation rate for the month was reported last week). Despite political pressure, particularly from France, the ECB is not in a position to shape their policy around curtailing the value of the euro. The only respite that can be expected here is for Trichet to reiterate previous remarks about a strong US dollar being in the best interests of the US. It is neither his place nor that of the ECB to try to influence the value of the euro against the dollar and the forum for any action on that matter will probably rest inside the G7 group of meetings, and not with the ECB. However the other major issue that the ECB must take into consideration this week is the deterioration in euro area economic data, particularly over the past month. Unlike last month when reduced economic sentiment could have been attributed to the credit woes in financial markets, there is now growing evidence of an industrial slowdown in the euro area economy, with both manufacturing and non-manufacturing sectors in decline across all the major economic blocks of the euro zone. While expectations of an interest rate reduction at this stage are premature, economic interests in the euro area as a whole will be looking for a deliberate shift in ECB monetary policy this week. Expect the ECB to acknowledge downside risks to growth, but to make direct reference to upside risks to inflation. Also expect Trichet to avoid using the ‘vigilance’ word and the core message that markets will probably extract from this week’s policy meeting is that euro area interest rates are now likely to remain unchanged through to the end of this year. Such an outcome will likely see the euro come under pressure, though the euro will probably lose most of the ground in the days leading up to the meeting.

BoE: October 4
Many analysts see the possibility of rate cute from the Bank of England this week, with the probability currently around 40%. The Bank’s Governor has a major credibility issue hanging over him going into this week’s MPC, following the fiasco of the public run on the Northern Bank early last month and the BoE’s u-turn on providing supportive financing during the credit crisis. The BoE also got their inflation forecasts completely wrong this summer and with inflation easing to an annualised 1.8% in August and the housing sector starting to cool, the Bank may feel obliged to start cutting rates sooner rather than later. As the MPC’s chief hawk and policy spinner, Governor King must shoulder most of the blame for having completely miscued on the economy’s inflation risk and unless the BoE ease rates quickly the wider economy may start to slow sharply, following 5 interest rates rises since August 2006. With ample evidence of a global slowdown and downside risks to UK economic growth, there appears no logical reason for the BoE to hold off on a rate cut until later in the year. In addition, the Bank does not know the real impact of the credit crisis on the UK banking sector and it is best to err on the side of caution. They should act this week. Some of the more rational and dovish voices on the Committee are sure to push for a cut at Thursday’s vote and should they succeed, it could spell more trouble for Governor King in his position at the helm of the Bank of England. I see the chances of an easing this week at 50%. A rate cut would see a rapid demise of the pound, while even if the Committee stand pat, sterling may still come under pressure as markets are likely to price in a cut for later in the year.

Ted Bearstruck
2nd October 2007

The Fed’s Options

Fed: Sep 18
The US Federal Open Market Committee meet next Tuesday on what is probably the most important meeting for the Committee in 4 years. Recent financial market turmoil coupled with a slowing US economy has put the focus firmly on the Fed, with markets demanding an immediate easing in US interest rates and a shift in the Committee’s monetary policy stance. The Fed effectively moved from a tightening bias to a neutral stance in August, when it lowered its lending discount rate and issued a statement stating financial markets stresses now posed a downside risk to the growth prospects of the US economy. Last week’s payroll report which revealed a contraction in employment for the first time in 4 years, has, in most analysts minds, sealed a rate cut for the September 18th meeting, with futures markets pricing in a near 50% chance of a 0.5% rate reduction. While a rate cut seems probable, the Fed finds itself in an incredibly difficult position because recent surges in energy costs on the back of a weaker dollar pose a major inflation threat to the US economy going forward. The Fed must weigh up the risks and deliver a decision that will best serve the sustainability of US economic growth.

The Fed has a number of options available to it, which I explore below:

1) What I consider the most likely outcome is that the Fed will reduce the funds rate by 0.25%, while maintaining its inflation bias. The Fed will probably modify the statement with a sentence along the lines of ‘The Fed assess there are increased downside risks to the US economy in the coming quarters and the Committee will act in a timely fashion, when needed, to support US economic growth.’ This in essence will move the Fed into a neutral position and enable it to hike or cut, depending on how the economy plays out in the months ahead.

2) The Fed reduces the fed funds rate by 0.5% and shifts to an easing bias. This is what many market analysts have been calling for and was the most likely outcome as early as last week, according to futures markets. While this would certainly answer critics who accuse the Fed of not being proactive enough, it might translate into the Fed pressing the panic button and have them stand accused of merely being seen to bail out the financial markets. Outside of last week’s employment report, most other recent data does not imply a requirement for such a drastic move and in any event it seems highly unlikely that there could be consensus amongst all voting officials to cut the rate by 50 basis points.

3) The Fed cuts by 0.25% and shifts to an easing bias. This is a possibility but not a probability in my view. To shift to an easing bias the Fed would have to soften its concerns on inflation, signalling downside risks to economic growth now outweigh current inflation concerns. This will be interpreted by many as a confirmation that the US is headed for a serious slowdown/recession and that the market should expect a cycle of rate cuts in the months ahead. This would be damning for the dollar, should it happen. However, there is insufficient wider economic data to support such a negative view at this time and such a policy decision could in itself precipitate a major slowdown/recession.

4) No change in the Fed funds rate, but a modification in the statement to stress that the Fed are monitoring the situation closely and will act when needed. The Fed could throw in a 0.50% reduction in the discount rate to offset against the resultant disappointment in financial markets. This particular option is probably the wisest one in terms of acting in the the long-term interests of the US economy, but it will require incredible bravery on the part of the Fed. It is also likely this is the preferred option of a number of Fed officials, including Bernanke himself and if the Fed Chairman manages to deliver such a result he will cement his place in history as a Central Banker that stood tall against all the pressure, influence and power financial markets could garner to unsettle him. If we did not have the recent credit market crisis, there is no question but that the Fed would not be even considering a reduction in the fed funds rate next week. Given that the crisis was created by the financial markets themselves and the fact that no interest rate reduction is going to recover bad debts, the Fed should leave the fed funds rates unchanged next week. Other Central Bankers have shown little empathy for financial markets in response to this mess, so why should the Fed be any different?

What about the dollar?

The dollar has been sold off at a rapid rate in the past 2 weeks, to the point that the US dollar index has firmly broken below 80 and sits at its lowest level in 15 years. The market has priced in rate cuts of between 0.75% and 1% between now and the end of the year. Although it is clear the dollar sell-off is overdone, the dollar simply cannot attract any sustainable buying support right now because of the extent of negative sentiment that surrounds it. We are unlikely to know the true fate of the dollar until after next Wednesday, once the true implications of Tuesday’s Fed statement has sunk in. We could easily see EUR/USD break above 1.40 or 1.41 in the immediate aftermath of Tuesday’s meeting, if the Fed shift to an easing policy, as the market is exclusively dollar bearish right now. But we could see a knee-jerk reaction on either side come Tuesday which may prove to be premature and it is a dangerous time to be entering the market.