What Could Turn the Dollar Around?

I was on Fox Business earlier this afternoon talking about what could turn the dollar around.

Here is a chart showing how G7/G8 (which is now G20) finance ministers and central bankers meeting has coincided with major tops and bottoms in the EUR/USD. I’ll have more on that soon at FX360.com

Dollar Unfazed By Mixed Economic Data

The US dollar appears to be unfazed by this morning’s mixed economic data. An improvement in consumer confidence has failed to help the dollar while the weaker news has pretty much been baked into the markets.

Christmas and New Years week is a time when traders are more focused on seeing family than making profits. It is probably truer this year than most because of the sharp volatility in the financial markets and the deep losses endured by most investors.

Third quarter GDP remained unrevised at -0.5 percent even though personal consumption slipped and core prices eased. Investors are more worried about the Q4 numbers than the Q3. The global recession and the stronger dollar could take a big bite out corporate earnings and growth.

The housing market also remains weak with new home sales falling for the fourth consecutive month and existing home sales falling by the largest amount on record. Sharp discounts on new homes is helping to slow the pace of falling demand.

The one piece of good news that we did see this morning was consumer confidence which was revised upwards in the month of December. Given that almost everyone knows someone that has been laid off, the price of gasoline is the only reason to cheer this holiday season. Prices at the pump have fallen close to 60 percent from its summer highs. For drivers, lower gas prices is like a tax cut. At a time when salaries are being frozen and bonuses are being reduced, a tax cut in the form of lower gasoline prices is welcomed with open arms.
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December FOMC Preview: How a 50 or 75bp Rate Cut Will Impact the Dollar

Tuesday’s FOMC meeting will be remembered for decades to come as the Federal Reserve brings interest rates down to the lowest level this generation has ever seen. With 2 realistic options on the table and economist and traders divided on how much the Fed will cut interest rates, the only certain outcome is significant volatility for the currency market. The US dollar is selling off aggressively going into the rate decision as traders realize that after tomorrow, the dollar will either be the lowest or second lowest yielding G10 currency.

No matter how you look at it, an interest rate of 0.50 percent is just as bad as an interest rate of 0.25 percent.

Federal Reserve: 50bp vs. 75bp

The decision of cutting interest rates by 50 or 75bp is really a decision of how quickly the Federal Reserve wants to formally move to Plan B, or Quantitative Easing. If rates are not taken to 0.25 percent tomorrow, then we could see that level reached in the first quarter of 2009. Fed funds contracts are currently trading at 0.15 percent, which means that any rate cut by the Fed will only be symbolic. The futures contracts are pricing in a 74 percent chance of a 75bp rate cut and a 26 percent chance of a 50bp cut, but only 11 out of the 95 economists surveyed by Bloomberg expect interest rates to be cut by more than 50bp. Either way, someone will be proved wrong tomorrow and that could trigger a big move in the US dollar.

Economic data has deteriorated significantly since the last monetary policy meeting and in our opinion, the right thing for the Fed to do is to cut interest rates by 75bp tomorrow and not delaying the inevitable. With the US economy falling into a deeper recession, rationing monetary policy stimulus now could be counterproductive. However, the Federal Reserve may not want to back themselves into a corner by taking interest rates down to 0.25 percent so quickly and therefore many economists argue that a 50bp rate cut is the most likely scenario.

Another reason why the dollar is selling off is because if the Fed eases by only 50bp, they could still signal that interest rates are headed to zero, which would also be negative for the US dollar. The only reason why the dollar could rally following the rate decision would be if the Fed signals to the market that zero interest rates is not a possibility. Unlike Japan, deflation has yet to hit the US and zero interest rates could intensify problems that the repo market and money market funds are already facing. Demand is waning in the repo market as the return is insufficient to cover the risk of failure.

FOMC Statement Needs to Answer 3 Questions

In many ways, the FOMC statement is even more important than the actual interest rate decision. There are 3 questions that the market expects the Fed to answer in the accompanying statement:

1. Are interest rates headed lower?
2. Will interest rates be taken to zero or will we see a BoJ style rate cut that takes interest rates somewhere between 0.25 percent and zero?
3. What is the plan for Quantitative Easing?

Since a full percentage point rate cut is off the table, the Federal Reserve will need to signal whether interest rates will continue to fall and by how much. Although everyone is thinking about rate cuts in quarter point clips, the Fed could take another page out of the Bank of Japan’s book and ease interest rates somewhere between 0.25 percent and zero in March. In other words, 0.15 percent could be the low in US interest rates next year instead of zero. Any hint of this possibility could have a big impact on the currency market. The FOMC statement could also include details for Quantitative Easing. For many people, QE is a new concept that has only one precedent and therefore the Fed may want to offer some transparency.

What Happens After Zero?

When a central bank runs out of room to cut interest rates, they resort to Quantitative Easing. This term was coined by the Bank of Japan in 2001 when interest rates were already at zero and the central bank stopped targeting the overnight call rate and turned to targeting a current account level. Their goal was to flood the Japanese financial system with liquidity by buying trillions of yen of financial securities including asset-backed instruments and equities.

It can be argued that the US has already engaged in Quantitative Easing as the government has recently announce plans to spend $800 billion to unfreeze the consumer and mortgage market. They have agreed to buy mortgage backed securities backed by government sponsored entities and could accelerate that if interest rates hit zero. Excess reserves have also increased significantly, driving the effective fed funds rate well below 0.5 percent. This would have been one of desired outcomes of quantitative easing. Last month, Fed vice chairman Donald Kohn said quantitative easing measures were under review at the central bank as normal contingency planning. The goal would be to encourage banks to lend more aggressively by coming in as a buyer at specified rates. Even though quantitative easing drove Japan into deflation, it was the key to turning around the economy and this is a risk that the US central bank may have to take.

Implications of the Fed’s Rate Decision on Currencies

The weakness of the US dollar against all of the major currencies reflects the market’s expectation that after Tuesday, the US dollar could yield less than the Japanese Yen. If that comes to reality, we could see further weakness in the US dollar against all of the major currency pairs but if the Fed only cuts by 50bp, there could be a violent move in the US dollar depending upon the tone of the FOMC statement.

The following table illustrates how key pieces of US economic data has changed since the last monetary policy meeting. Although consumer confidence has improved and we are beginning to see some upside surprises in US economic data, the trend of most data still points to dollar bearishness.
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Dollar Soars as FOMC Minutes Trigger Liquidation

Despite false rallies in the currency market, I have stressed that there is no reason for the liquidation to be over. I warned that the currency and stock market rallies were a mirage rather than a bottom and now, the pessimistic tone of the FOMC minutes has forced another wave of liquidation.

Tuesday’s rebound in risk appetite was short-lived as the FOMC minutes revealed that the contraction in the US economy could last well into the summer of 2009.

In light of the 400 point drop in the Dow, the US dollar and Japanese Yen regained strength as repatriation and risk aversion continues to drive demand for the low yielders. The greenback’s recent strength can be most clearly seen in USD/CHF, which hit a fresh 14 month high today.

As we predicted, the FOMC minutes was the trigger for a major move in the currency market. However the moves that we have seen today need to be sustained before we can see a more meaningful breakout of the recent consolidation that we have seen across the currency market.

Something more powerful such as a decision on bailing out the automakers, next week’s GDP report or another surprising abysmal loss in the corporate or financial sector may be needed before we see new trends develop.

FOMC Minutes Confirms that More Rate Cuts Needed

The tone in the FOMC minutes, like the tone of Bernanke’s testimony yesterday was unmistakably dovish. The members of the monetary policy committee lowered their growth and inflation forecasts, talked about the downside risks to growth and how the contraction in the US economy will not temper until the middle 2009, at the earliest. Some members of the committee even openly discussed the need for further rate cuts, which confirms that rates will be lowered again in December. The Fed feels frustrated that interest rates are closing in on zero and acknowledged that it leaves them with little room to maneuver. Fed fund futures are pricing in a 50bp rate cut with a minor chance of a 75bp cut to 0.25 percent. If the Fed cuts interest rates by 50bp and the US economy fails to recover, their credibility will go out the window as the market questions their ability to tap other tools to stimulate the economy.

Automakers, Philly Fed and Leading Indicators

The Big 3 Automakers (General Motors, Ford and Chrysler) were on Capitol Hill today pleading for a bailout. Although a bailout of the automobile industry is inevitable in our opinion, it remains to be seen whether lawmakers will act quickly. The longer this drags out, the more pain it will cause for US equities.

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In the Financial Papers: Today’s Top Forex News 06.26.08

kathysmallHere is the “In the Financial Papers Radio Broadcast” (Length: 4:41 minutes). The player should load automatically. Please let me know if you like it. Contact Kathy

In the Financial Papers:

 

Podcast Covers:
Fed Sounds Inflation Alarm, Takes `Baby Step’ Toward Raising Interest Rate
Volvo to Cut 8% of Global Staff
JC Penny Slashes Opening Plans
Trichet denies Speculators Cause Oil Rise > major issue still supply and demand
Bernanke Keeps His Options Open
Nobody’s Snapping up GE Plastic
LSE to Open Doors to Pan European Trading
EU Steepening Trades
ECB Noyer: Trichet didn’t say that a July hike was the start of the cycle

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