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The US dollar is on steroids this morning as the sell-off in global equities sends the dollar to a 2 year high against the Euro. The EUR/USD is within 3 percent of its fair value of 1.20 while the GBP/USD and USD/JPY are now undervalued on a purchasing power parity basis. However PPPs matter little in a market environment that is driven by fear. The currencies have overshot their PPP levels for years and there no is reason why they can’t undershoot them as well. We still believe the dollar is nearing a top as the stock market attempts to stabilize, but bear market sell-offs can last for far longer than what may seem logical.
Central banks are having a very tough time dealing with the sharp moves in both the equity and currency markets. Investors continue to bail out of the funding currencies of high risk investments like carry trades, stocks, bonds, real estate, emerging markets and commodities.
Risk of G7 Intervention
The G7 released a statement on the Japanese Yen this morning, but it was all talk and no action which suggests that the Japanese are having a hard time convincing their US and European counterparts to join in on any physical intervention to sell the Yen. It is certainly not in the US’ best interest to engineer further strength in the dollar. The Japanese will have to act alone if they plan on engaging in physical intervention because the ECB will not back Yen intervention either as a weak EUR/JPY is good for exports.
Coordinated Rate Cuts
A higher probability scenario is another round of coordinated interest rate cuts by major central banks. The strength of the US dollar and Japanese Yen have been driven entirely by the weakness in global equities. Another coordinated rate cut could stabilize stocks which would help to take some of the steam out of the US dollar and Japanese Yen.
At minimum, the latest rally in the US dollar will give the Federal Reserve a stronger reason to cut interest rates by 50 instead of 25bp. Fed fund futures are currently pricing in a 68% chance of a half point rate cut and 32% of a 75bp rate cut. A quarter point rate cut has been completely discounted by the markets. To deliver anything less than a half point cut would be a big disappointment.