Dollar Suffers Fed's Appetite Injection
We mentioned in our piece from last Tuesday "Data Vacuum = Risk Appetite" that gold would "extend gains towards the $730 level before next Wednesday", NZDUSD would target "0.7208" and USDJPY seen breaking above 115. Indeed, today's FOMC decision made those predictions a reality. More projections are found below after our take on the Fed's aggressive action.
Just as former Fed Chairman Greenspan was shadowing Chairman Bernanke with his autobiography, Mr. Bernanke stole the show back by delivering an unlikely 50-bp rate cut in today's meeting. The FOMC opted for the aggressive option of cutting the Fed funds rate by 50 bps to 4.75% (first 50bps cut since Nov 02) and the discount rate by 50 bps to 5.25%.
With the discount rate at 5.25% and the funds rate at 4.75%, today's increased the difference between the two rates to 50 bps, the same margin prevailing before the August 17th 50-bps rate cut in the discount rate. This may mean that the Fed's next policy easing would target the discount rate by 50 bps, bringing it down to the same level of the Funds rate. Recognizing that discount borrowing was on the rise last week to its highest level in 6 years at $7.2 billion, the Federal Reserve will want to preserve the effectiveness of the discount rate by cutting the funds rate at subsequent actions (whether scheduled or unscheduled meeting) and trigger a positive shot in the arm for the markets.
It is plausible that today's 50-bps cut in the funds rate was aimed at stabilizing market confidence and shoring up liquidity with the intention of seeing improved market dynamics help the economy, while stepping back and exploring the macroeconomic landscape, including the upside risks to inflation.
This argument is based on the rationale that the macroeconomic data, while pointing to clear evidence of weakness (home prices/sales, construction spending, retail sales, jobless claims), the deterioration has been slow and gradual. Despite showing declines, ISM services and manufacturing remain above 50, never a coincident figure for 50-bp cuts. And despite weakening payrolls, jobless claims have yet to display aggressive gains as they are only at 4-month highs. Finally, measures of consumer confidence remain modestly weak and well above the lows of the market turbulence of 1998 and 2001.
Consistent with the aforementioned analysis, the FOMC reminded markets that "some inflation risks remain, and it will continue to monitor inflation developments carefully". This is an important reminder considering the central bank considering that it made no mention of its much touted inflation risks at the inter-meeting rate cut of August 17.
With the new post-Greenspan Fed proving its capability of starting the easing campaign with a unanimous 50-bp rate cut, currency markets are expected to engage in a combination of dollar-targeted trades (selling USD vs EUR, AUD, CAD and NZD), with a touch of risk appetite trades weighing on the Japanese yen to the benefit of EUR, CAD, NZD and GBP. Unlike in 1998 and 2001 when Fed rate cuts boosted the dollar, the current global economic landscape is characterized by a unique decoupling of central bank policies from that of the Federal Reserve. Even if the ECB, BoE, RBA and BoC remain on hold, a lack of easing is already a positive for their currencies against the US dollar.
NZDUSD: Eyeing 73 cents and beyond
We continue to remain bullish on the Kiwi as the combination of reemerging carry trades, a cautiously hawkish RBNZ and a deteriorating US dollar yield foundation. With the NZD rate advantage relative to the USD rising to 3.50% from 3.00%, further NZD gains are in store. In the short-term, the pair is likely to gain from renewed risk appetite as further Fed easing is anticipated. Once a deteriorating jobs picture supports the case for further rate cuts, we could extend gains towards 0.7400. Interim resistance stands at 0.73, followed by 0.737.
GBPUSD: More downside to come
The high yielding currency was among the first to rally from the Fed's dosage of risk appetite and Bernanke's move is exactly what was ordered for the beleaguered currency. When the impact of the rate cut is played out-possibly after fresh evidence of weakness in the UK we expect sterling to resume its selloff -- even against the US dollar -- to as low as $1.9850. Barring the dollar-damaging rate cut from the Fed, UK CPI slowed to 1.8% in the year ending in August, following 1.9%, posting the lowest level since March 2006. The core CPI rose to 1.8% from 1.7%. For the inflation-targeting central bank which wrote a letter to the Treasury less than year ago explaining inflation's breach above the 2.0% target, today's report is a blow to the BoE's hawkish camp as it shifts the focus onto the credit crisis and the nascent signs of slowing home prices. We expect BoE interest rates to have topped out at 5.75%, and see a 60% possibility of a 25-bp rate cut in December. We cautioned clients that a 50-bp Fed cut would "boost sterling as it will be a positive (but temporary) shot in the arm in risk appetite, while at the same time weighing on the dollar's yield base".
While the daily GBPUSD chart appears largely bullish, the weekly chart (below on the right) suggests prolonged selling into the rest of the week, witt $2.0070 being the next interim target, followed by the 200 day MA of 1.9890. Upside capped at $2.0175.
USDJPY: testing 116.35
USDJPY finally tests its 4-month trend line resistance of 116.35, which is coincides with the 38% retracement of the decline from the July 10 high. A breach of this level is likely to test the subsequent target at 116.70, but the likelihood of further gains is doubtful. A soft US CPI on Wednesday is theoretically dollar negative, but with the Fed reminding that it remains worried about inflation, a low CPI figure would be welcomed by the markets as well as the risk seeking yen bears. But markets must also be cautioned of the US data on August housing starts and building permits due at the same time as CPI, and which are expected to have dropped to 1.35 mln from 1.38 mln and to 1.35 mln from 1.373 mln respectively.
Although the dollar's upside is on the cusp of extending to new technical highs, the currency's fundamentals remain dubious at best. A rise to 117, followed by a 2-day drop towards 114.67-70 remains a high possibility. It is also plausible that the Philly Fed survey due Thursday will come in worst than expectations of 4.0 in September from 0 in August, which may have been a factor in the Fed's decision to cut by 50 bps.