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Pandemonium has hit the financial markets. The dollar is trading below parity against the Swiss Franc, it has fallen to a new record low against the Euro and to a new 1995 low against the Japanese Yen.
Will the Dollar Continue to Fall?
Yes. The futures curve is currently pricing in a 90 percent chance of a 100bp rate cut and a 6 percent chance of a 10 percent rate cut. By the end of June expect rates to come down to 1.5 percent. This is the minimum that the Federal Reserve must do to stabilize the financial markets.
If they want to put an end to the pain however, they will need to be more creative. The discount rate cut on Sunday is not enough. What is 25bp really going to do for the markets? Banks are in seizure mode and are focused on nothing but minimizing counterpary risk. LIBOR rates are skyrocketing and everyone is holding their breath, waiting for the next shoe to drop. For this reason, the dollar and carry trades will continue to weaken.
Will there be Intervention?
Not anytime soon. The Japanese have expressed concerns about disorderly movements, but since their last intervention in 2004, their top priority has been to convince China to revalue their currency. I doubt that they will be willing to risk the past 4 year’s efforts 3 weeks before the finance minister’s meeting in Washington DC and 4 months before the G7 meeting that they will be hosting.
As for the ECB, they are worried about sharp and excessive moves, but they have their eyes peeled on 1.60. As long as we hold below that price level, I don’t expect any verbal intervention because in 2004, the EUR/USD rallied 13 percent in 2 months before the ECB called the move brutal. If we count 1.59 as the high today, the EUR/USD has only appreciated 10 percent over the last 2 months. The ECB’s top priority is inflation. The strong Euro is cushioning the pain on high commodity prices.
Don’t expect the Fed to come out and buy dollars either. They need a weak currency to draw in foreign investors that may be looking for value and to boost exports.
However this is not to say that there couldn’t be a coordinated liquidity injection or a similar move reflecting solidarity amongst global central bankers.
What about Carry Trades?
With high volatility in the stock market, and 300 point swings in currencies, don’t expect a recovery in carry trades either. If anything, expect further weakness in USD/JPY to drag the other yen crosses lower. The demise of Bear Stearns has made everyone gun shy. I am sure that risk managers across Wall Street banks are on red alert, forcing their traders to minimize risk.