JPY Breaks 83: Time for Intervention?

Prime Minister Kan won the elections last night and Yen traders have interpreted his victory to mean a more relaxed approach towards intervention. This may be true when compared to the pro-intervention stance of Ozawa (his challenger) but the rapid appreciation in the Yen against the U.S. dollar AND the Chinese Yuan has also made Kan more likely to intervene in the currency. Even if he was not actively considering physical intervention to weaken the Yen before the elections, he will have warmed to idea when he wakes up in the morning and finds USD/JPY trading below 83.

Yen Strong Against the Dollar and Yuan

Although we are all focusing on the USD/JPY rate, which is trading at its weakest level since April 1995, the Yen is also trading at a record high against the Chinese Yuan despite the fact that Yuan has reached a record high against the U.S. dollar. The recent strength of the Yuan increases the pressure on Japanese government to intervene in the Yen because it reduces the competitiveness of products made in Japanese over China.

USD/JPY Tracking Yields

USD/JPY is also breaking down because U.S. yields continue to fall. Goldman Sachs made the bold call this morning that the Fed could announce additional asset purchases in November and it is having a significant impact on the financial markets. The retail sales number also failed to make U.S. investors more optimistic about the recovery.

At this point there is no major support in USD/JPY until its record low of 79.75.

Time for Intervention?

However I don’t think that the Japanese government will let USD/JPY fall to its record low of 79.75 without intervening. I have been skeptical of calls for intervention since July when USD/JPY fell from 88 down to 83.00. However, everyone has a bottom line, or a point at which they will eventually cry uncle, and for Japan, this level should be around 80, right above the currency pair’s 15-year low. Never before had the Japanese government let USD/JPY fall below 79.75, which was not only the April 1995 low, but also the record low. Now that USD/JPY has fallen below 83, the risk of intervention has increased ten fold and I expect that we’ll go from empty threats to a real battle against yen strength. USD/JPY has now entered the intervention territory which is between 82 and 79.75 and the Bank of Japan could come into the market at anytime. Anyone who is long the Yen needs to be very careful.

The latest CFTC data shows that long yen positions are near record highs, which is exactly what the BoJ likes to see before they intervene in the currency because it provides the best bang for the buck as the stopping out of these short positions will exacerbate the rally in USD/JPY.

Which Central Bank is Back in the Market?

Although everyone’s focus is on the Federal Reserve’s interest rate decision this afternoon, we have a lot of action in the European currencies. If you notice, the Euro is one of the few major currencies to under perform the dollar this morning because of the massively well subscribed ECB refinancing. In my daily report on FX360, I have mentioned how the EUR/USD could pull back because European banks look at the refinancing as quasi Quantitative Easing.

Although this is a big story, central bank intervention is the big focus this morning. The Swiss National Bank is at it again! They have sold Swiss Francs aggressively, driving EUR/CHF and USD/CHF up more than 1 percent. Last week, I talked about how a move down to 1.50 creates a good risk / reward opportunity. EUR/CHF fell to 1.5007 last night, which probably triggered alarm bells at the SNB.

Here is a chart of the move in EUR/CHF this morning. On FX360, I posted a more thorough analysis as well as charts from previous SNB interventions.

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Switzerland to Charge Forward with Currency Intervention

The Swiss National Bank has been intervening in the currency market since March. Unlike other central banks who have failed at intervention, the SNB has done a fantastic job keeping EUR/CHF above 1.50 for the past 3 months. The SNB focuses on EUR/CHF over USD/CHF because the European Union is by far the country’s largest trading partner. The Swiss National Bank has a monetary policy decision on Thursday and interest rates are expected to remain at 0.25 percent. If they could, Switzerland would probably cut interest rates. The State Secretariat for Economic Affairs just released their latest economic forecasts. GDP growth is expected to contract by 2.7 percent this year compared to a prior forecast of -2.2 percent. The economy is also now expected to shrink instead of grow in 2010. Therefore the SNB will not be abandoning their loose monetary policies anytime soon.

However for currency traders, the more important takeaway from the meeting will be the Swiss National Bank’s reluctance to rescind its commitment to currency intervention. If that is the case, then current levels may present a buying opportunity for range traders as the SNB is likely to actively maintain this incredibly yawn inducing range in EUR/CHF.

Meanwhile the EUR/JPY trade that I posted earlier this week has hit its target of the first standard deviation Bollinger Band. The 50-day SMA now at 132.30 will provide some support but if that level is broken, we could see a move down to 130.

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FOMC Preview: Will the Fed Cut 25, 50 or 75bp?

The biggest event risk this week is undoubtedly the Federal Reserve’s monetary policy decision on Wednesday. Now more than ever, the Fed’s decision could turnaround the currency and equity markets. Since the last interest rate cut by the central bank on October 8th, the dollar has rallied more than 8 percent and the Dow Jones Industrial Average has fallen by more than 10 percent. The Fed’s half point rate cut at the time was a part of a coordinated effort with central banks from around the world including the ECB, the Bank of Canada, the Bank of England and the Swiss National Bank. With US interest rates now at 1.50 percent, the Fed will need to start rationing rate cuts going forward unless they want to take interest rates to zero.

Going into the FOMC meeting, economists can’t seem to agree on how much the Federal Reserve will cut interest rates. Of the 64 economists surveyed by Bloomberg:

53 percent expect a 50bp rate cut
26.5 percent expect a 25bp cut
19 percent expect interest rates to remain unchanged
1 lone economist or 1.5 percent of the people polled expect a 75bp rate cut.

Fed Funds traders appear to be more optimistic as they have already priced in 50bp of easing for Wednesday with a 32 percent chance of a 75bp rate cut.

The recent strength of the US dollar will add pressure on the Federal Reserve to make a larger interest rate cut but everyone needs to realize that the rate cut by the Fed this week will not be their last. Even though the national average of gasoline prices has fallen 35 percent, layoffs continue to rise. If GM and Chrysler are forced to cut back or worse, pushed into bankruptcy, unemployment will continue to grow. The US economy is expected to get worse before it gets better and the Federal Reserve will not want to back themselves into a corner quite yet; a larger rate cut on Wednesday would give them less room to cut interest rates in December.

Here are the 3 most likely outcomes for Wednesday’s monetary policy decision:

Coordinated Rate Cut by the Fed, ECB and BoE (Dollar Bearish)

The best and most effective option for the Federal Reserve would be to coordinate a rate cut with the European Central Bank and the Bank of England. All 3 central banks would get the most bang for their buck by working together. Given Monday’s comments by ECB President Trichet about cutting interest rates again in November, he may not be opposed to making the rate cut one week earlier. The Times of London has also indicated that the BoE is under pressure to cut rates as well. This measure of solidarity would send a strong message to investors and at the same time not require the Federal Reserve to take interest rates below 1.00 percent, leaving them little room to cut interest rates later. A coordinated rate cut to should be bullish for the global equity markets and bearish for the US dollar.

Independent 50bp Rate Cut from the Fed (Dollar Neutral)

Although a coordinated rate cut is the most effective option for the currency market, it may not be the most likely option because for whatever reasons, the ECB and the BoE may be opposed to coordinated intervention. Since an independent rate cut by the Federal Reserve is exactly what the market expects, the impact on the US dollar should be limited. The key will be the tone of the FOMC statement.

25bp Rate Cut (Dollar Bullish)

A 25bp rate cut will be a big disappointment to both the currency and equity markets. Given the degree of risk aversion and fear, we do not believe that Bernanke will risk the consequences of a disappointment since it could trigger another round of selling for stocks and high yielding currencies. In this type of market environment where investors are becoming immune to new measures taken by the US Treasury and the Federal Reserve, it pays to over deliver.

75bp Not a Viable Option – Too Close to ZIRP

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