US Dollar: Expect Only 25 and Not 50bp from the Fed

[B]- US Dollar: Expect Only 25 and Not 50bp from the Fed

  • Euro Rallies as Trichet Leaves Door Open for Resuming Rate Hikes
  • Bank of England Leaves Rates Unchanged and Releases Surprising Statement[/B]

US Dollar: Expect Only 25 and Not 50bp from the Fed
Although the focus in the financial markets is now on tomorrow?s non-farm payrolls report, traders should not lose sight of the bigger question which is how much the Federal Reserve will cut interest rates later this month. That is the only reason why NFP will be important, which is to act as a catalyst for the Fed. At this point, it is highly unlikely that the US central bank will forgo cutting interest rates since it is fully priced into the market and the consequences of not meeting the market?s expectations could be even more serious than trying to delay the inevitable by another month. The recent price action in the bond, stock and currency markets indicate that traders are nervous; everyone prefers to be in cash and gold with the price of the yellow rising significantly today. If the Fed did not cut interest rates, they risk triggering a complete repricing of the interest rate curve and a sharp sell-off in the stock market. In reaction to that, the US dollar would rally and carry trades would collapse. However even if we get a weak non-farm payrolls number tomorrow, a 25bp rate cut may be the best that the Fed will offer. The five Federal Reserve Officials speaking today held onto their belief that the problems in the US economy are limited and according to Poole and Lockhart, the US is near full employment, there is no major threat to job growth and no spillover from housing into the broad economy. In other words, they will only back a quarter point rate cut. In the meantime, non-farm payrolls are still important because a weak number will drive home the point that the real economy is being affected regardless of what Fed officials are saying. The laundry list of why non-farm payrolls could be weak tomorrow is endless. The employment component of the service sector ISM report released today dropped back into contractionary territory for the first time since September 2003 to match the lowest level seen since March of that year. At that time, payrolls increased by a mild 81k in September and dropped by 196k in March. We expect non-farm payrolls to be less than 100k in the month of August. For more details on how non-farm payrolls could fare, see our Special Report, “August Non-Farm Payrolls: What to Expect for the US Dollar” and How to Trade the US Non-Farm Payrolls through the EUR/USD.
Euro Rallies as Trichet Leaves Door Open for Resuming Rate Hikes
Even though the ECB left interest rates unchanged at 4 percent today, the Euro rallied as Trichet let the markets know that they have not given up on raising rates this year. The turmoil in the financial markets is a big concern for them and they feel that it is important to make sure that confidence is restored in the markets. This morning, the ECB added another EUR42.2 billion in emergency funds to calm the credit markets - a strong signal that their work is not done. Yet fundamentally, for the time being, the ECB still feels that the medium term economic outlook is favorable which is why they believe monetary policy remains accommodative. However, Trichet specifically said that he did not use the words “strong vigilance” in his speech which implies that the ECB do not plan on altering interest rates in October. They still think that the risk to price stability (inflation) is to the upside but they want to watch incoming economic data before deciding what to do next. Trichet indicated that he will bring back the words “strong vigilance” if and when necessary. Even though the ECB will mostly stand on hold for the remainder of the year, which may be how long it takes for the credit markets to calm down, Euro traders are simply relieved that the central bank has not suddenly turned dovish.
Bank of England Leaves Rates Unchanged and Releases Surprising Statement
The Bank of England left interest rates unchanged at 5.75 percent today but to the surprise of the market, they released a statement justifying their decision. For the other central banks around the world, this is a common act, but for the BoE it is not. The last time the BoE ever released a statement after they left interest rates on hold was in May 1999. Clearly, their decision to do so today is an attempt to let the markets know that they are watching the credit crisis and not asleep at the job. This is especially true since there was not much in the statement other than the fact that evidence of companies or households being affected by the disruption in the financial markets could be enough reason for the BoE to lower interest rates. The BoE is an exceptionally dynamic central bank that will not hesitate to shift monetary policy if necessary.
Australian and Canadian Dollars Rally on Strong Economic Data
The Australian, New Zealand and Canadian dollars all rallied strongly today on the combination of higher commodity prices and stronger economic data. Australia reported much stronger than expected employment numbers for the month of August. The economy is doing very well and this has not gone unnoticed for currency traders who are looking to buy the strongest country or currency and sell the weakest. Although New Zealand commodity prices were softer than the prior month, the rally in the Aussie drove the kiwi higher as well. Meanwhile a firm IVEY PMI number in Canada also helped the Canadian dollar recover some of yesterday?s losses. CAD employment numbers are also due tomorrow. The increase in the employment component of the IVEY suggests a similar improvement in jobs.
Carry Trades Stuck in a Range
The Japanese Yen crosses have been stuck in a range for the past week as the market tries to figure out whether we are simply in the eye of the storm or if the worst is really behind us. Non-farm payrolls will go a long way in helping to resolve some of this confusion for anyone who is on the fence. We believe that more losses are to come and carry trades, which still have not recaptured the highs that they made in the last week of August, are still in a broad downtrend. There is no significant Japanese data expected to be released tonight.

Written by Kathy Lien, Chief Currency Strategist of