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US Dollar: Rate Cut Expectations Drop Significantly

Wed, Oct 10 2007, 06:13 GMT
by Kathy Lien

DailyFX

• Carry Trades Rise Ahead of Bank of Japan Rate Decision

• ECB Trichet Says Exchange Rates Will be Discussed at G7

US Dollar: Rate Cut Expectations Drop Significantly
With no US economic data released this morning, traders were sitting at the edge of their seats waiting for this afternoon’s FOMC minutes. Unfortunately the minutes failed to deliver any sort of cohesive market activity. Even though the US dollar firmed against the Japanese Yen, it lost value against the Euro, British Pound and Australian dollar in the hour after the FOMC minutes were released. Although the mixed performance of the US dollar leaves many traders scratching their heads about what to make of the report, the reaction in the bond markets clearly tell us that the number should be interpreted as dollar bullish. The market went from pricing in a 50-50 chance of a rate cut at the end of the month to a 35-65 chance for an October cut. The decision to cut interest rates last month was unanimous. The minutes did not reveal much about what the Fed will do going forward, but it did indicate that the Fed cut both the discount and Fed Funds rate to forestall some of the adverse effects on the economy that might otherwise arise. This suggests that the move was proactive and not reactive and our interpretation is further supported by the Fed’s view that to date, initial claims for unemployment insurance did not indicate that labor demand has weakened significantly. They even said that several sectors were reporting shortages of labor while inflation remains a concern. At the time, the Fed was worried that inflation pressures would rise if the US dollar depreciated further. Now that it has, the inflation risks are probably greater. We expect to see a sharp rise in the producer and consumer prices over the next two weeks which will impact how the dollar moves. Comments from Federal Reserve President Poole also support the case that interest rates will be left unchanged at the end of the month. Poole said that the most recent jobs data indicates that the economy has yet to deteriorate as much as economists are expecting. When asked about the dollar, he simply said that the depreciation is “inexplicable.” The bottom line is that today’s FOMC minutes should be bullish for the US dollar and it may be just a matter of time before the currency reacts that way.

Carry Trades Rise Ahead of Bank of Japan Rate Decision
Japanese Yen crosses are rallying ahead of this evening’s Bank of Japan interest rate decision. The central bank is widely expected to leave interest rates unchanged because deflation remains a constant battle. Earlier this week we had talked about how the cell phone price war in Japan is driving prices lower. Today, convenience stores were split on whether to raise food prices on some products despite an increase in their own costs. Although the problems in the credit markets have subsided, the fact that the Federal Reserve has initiated the trend of lowering interest rates makes a rate hike by the Bank of Japan stick out like a sore thumb and Japanese growth has not been stellar enough to warrant a rate hike. Meanwhile carry trades are back in vogue following the sharp gains in the US equity market. The Dow closed at a fresh record high of 14164. It is earnings season in the US, so equities could swing either way depending upon how earnings fare - should stocks continue to rise, so will carry trades.

ECB Trichet Says Exchange Rates Will be Discussed at G7
ECB President Trichet said that exchange rates will be discussed at the upcoming G7 meeting, but it seems that the currencies in question will be Chinese Yuan, US dollar and Japanese Yen. He did not say that the Euro was one of the problems and this view continues to be supported by German officials. The latest comments come from Germany’s Finance Minister who explicitly indicated that he supports a strong Euro. Unsurprisingly, the German trade surplus narrowed in August. The impact of the currency’s rise continues to be more apparent in German data than French data even though the French have been screaming far louder than the Germans about the current level of the Euro. During the same month, the French deficit actually improved. Euro bears should not expect to get any support from the ECB in the near future.

Australian and Canadian Dollars Head Back Towards Multi-Decade Highs
The Australian, New Zealand and Canadian dollars headed back towards their multi-decade highs on the back of a bounce in the commodity markets and renewed demand for high yielding currencies. Canadian and New Zealand economic data supported the move, but Australian data did not. Exemplifying the strength of the economy were Canadian housing starts which hit the highest level since 1979 in September. New Zealand business confidence also improved from -37 to -27, but Australian business confidence dropped to an 8 month low. Consumer confidence from Australia is expected next. The price action of all three commodity currencies supports further gains.

British Pound: Sharp Intraday Reversal
After dropping to a low of 2.0257 at the beginning of the US trading session, the British pound staged a very impressive intraday reversal to end the US trading session well above 2.0350. The move appears to be almost completely dollar driven since it came hours after the release of the UK trade balance. Although the deficit narrowed in the month of August, the improvement was less than the market expected. UK Chancellor Darling maintained the government’s 2007 growth forecast of 3 percent, but revised down the growth forecast for 2008 from 2.5-3 percent to 2-2.5 percent. Leading indicators are due for release tomorrow along with the RICS house price index. Both are expected to deteriorate given the problems in the UK financial market and the strain of a strong currency and high interest rates.

Published on  Wed, Oct 10 2007, 06:15 GMT