USD/JPY: Headed to 85

The US dollar continued to hit new decade lows against the Japanese Yen and is inching closer to my 85 target. As you can see in the chart below, there is no support from here to 85. With US interest rates below Japanese rates, more adjustment is happening in USD/JPY.

Source: eSignal

Source: eSignal

I do not think we will see much yen strength past 85. Although the Bank of Japan will not physically interven in the currency market anytime soon, verbal intervention may be on its way.

Also, Fed fund futures suggest that we may have seen the last interest rate cut from the Federal Reserve:

Here are updates on my recent trade calls, hope you banked some of this

12.16.08 USD/JPY to 85 (bottom of article) > FLOATING PROFITS

12.16.08 EUR/USD Headed to 1.43 (bottom of article) > HIT!

12.15.08 AUD/USD Headed to 0.70 > HIT!

12.11.08 EUR/USD Headed to 1.35 >> HIT!

12.08.08 EUR/GBP Headed to 0.90 >> HIT!
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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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Facts and Figures from the Financial Turmoil

So far this morning, central banks around the world have injected more than $200B in the financial system. Here are the figures:


And here are some facts about yesterday’s (9.15.08) price action:

USD/JPY – Biggest one day drop in 9 years

S&P500 – Biggest one day percentage drop since 9/11

30 Yr Treasuries fall to lowest level in 45 years

Fed Funds – Largest range since August 2007

Federal Reserve Liquidity Injection – Biggest since 9/11

Are we in unprecedented times? Yes.

The markets are pricing in a 100% chance of 2 rate cuts by December:

Dow 10k Could Mean USD/JPY at 100

On Friday, the Dow hitting 10,000 still seemed to be a remote possibility, but today, that is starting to become a reality. We have warned on near daily basis about the danger of carry trades. Although the EUR/USD’s reaction to the systemic risk in the financial markets was not as clear, there was a clearly negative implication for USD/JPY. Not only did we talk about the 70 percent correlation between the S&P 500 and USD/JPY, but there is also a similarly tight correlation between USD/JPY and the VIX index, which measures the volatility of the stock market. This means that the weakness in stocks and the rise in volatility drove USD/JPY below 105. To put today’s move into perspective, the drop in US stocks today was the most since the September 11 attacks in 2001. Unless stability returns to the financial markets, all of the Japanese Yen crosses including USD/JPY will continue to suffer.


Since the beginning of the year, we have lost 3 of the largest investment banks on Wall Street and such unprecedented developments have called for unprecedented actions by US government and Wall Street officials. Since the announcement of Lehman Brothers filing for bankruptcy and Bank of America taking over Merrill Lynch, AIG has been given special permission by US authorities to tap into $20bln of its own capital to prevent a liquidity crisis and credit downgrades. The Federal Reserve is also holding a special meeting to discuss possible remedies to AIG’s problems. The ECB and the Bank of England have pumped more liquidity into the financial system while the Federal Reserve made an unusual intervention to drive Fed funds lower.


Why Did Fed Funds Soar to 6 Percent when Futures are Pricing in a Rate Cut?

Fed fund futures are pricing in an 80 percent chance of a 25bp rate cut tomorrow by the Federal Reserve. This is a big change from last week, when the only thing that the market was thinking about was a rate hike. However despite this sharp shift in expectations, Fed funds surged to a high of 6 percent, 400bp above the Fed’s target rate of 2 percent intraday. This jump in the overnight lending rate between banks indicates that no one wants to take on risk. Trust is a commodity these days as the move in Fed fund futures suggests that no one knows if their counterparty will be here to survive another day. Fund funds gave back all of its gains by the end of the US trading session, but that does not mean that risk appetite has returned – quite the contrary. AIG is in big trouble, Washington Mutual is still on our watch list with their bonds now cut to junk status by Moody’s and the worries now turn to Goldman Sachs and Morgan Stanley who will be releasing earnings this week. Large write downs could drive a nail in the coffin for the US stock market and USD/JPY. Of all the pairs in the currency major, USD/JPY and other carry trades will be hit the worst. Over the past 3 years, there has been a 68 percent correlation between the VIX and USD/JPY, so higher volatility means trouble for the currency pair. Although consolidation in the banking sector was something many people expected, no one thought that the consolidation would occur because of Chapter 11 filings.

Will a Fed Rate Cut be Enough to Shore Up Confidence and Trigger a Reversal in the US Dollar?
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Correlation Between the Dollar and Fed Fund Futures

For currency traders, the most interesting article in today’s Wall Street Journal is the one about volatility in the financial markets causing trading relationships to be in flux.

This article examines some of the correlations that we talk about regularly, between USD/JPY and stocks or the EUR/USD and oil. The premise of this article is that these correlations may be fading, even though USD/JPY has traded in sync with the Dow today while the positive correlation between the EUR/USD and oil prices remain intact.

Correlations run hot and cold and even though the Wall Street Journal Article may have a point, there will always be times when correlations are strong and weak.

The one correlation that has remained intact so far is between USD/JPY and the December Fed Fund futures contract. Since March, the correlation between these two assets has been more than 90 percent. This tells us that the US dollar has been trading almost entirely based upon the market’s expectations for the Federal Reserve moves this year. Back in March, USD/JPY plummeted below 100 when Fed fund futures priced in steeper rate cuts. By June, the greenback recovered impressively against the Yen as oil prices surged forcing Fed fund futures to price in the possibility of rate hike before the end of the year. Interestingly enough, the correlation between the December Fed fund futures contract and the EUR/USD has been approximately zero between March and July.

The reason why the correlation is strong for USD/JPY but nonexistent for the EUR/USD is simple; everyone knows that Japan can not alter interest rates despite their economic conditions while the outlook for Eurozone rates remains uncertain. In contrast, weaker conditions in Japan have already been priced into the market, but no one knows for sure if the Eurozone will skirt a recession or whether the European Central Bank will deliver another rate hike this year.


This is an excerpt from my DailyFX Fundamentals report

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