Is it Safe Yet?

11/03/2008 10:01 am EST

Focus: FOREX

Brian Dolan

Chief Currency Strategist,

Good riddance October. A month that began with much hope as the US government pursued the housing/financial sector rescue package ended with unprecedented carnage in nearly every asset class, leaving few investors unscathed. Hedge fund and portfolio withdrawals forced asset sales, driving down shares worldwide and triggering margin calls, which prompted yet further selling. In currencies, this sent the JPY crosses (carry trades) plunging and the USD soaring. Additional government steps late in the month (Fed extension of USD swap lines to Brazil, Mexico, Singapore and South Korea; interest rate cuts from the Fed, China, Norway, and Japan; and the start of the Fed's commercial paper program, to name just a few) triggered sharp rebounds in shares and carry trades, but much of the damage remained. The economic outlook deteriorated still further as US 3Q GDP printed negative (and the details of the report were even worse than the headline reading), US and European confidence gauges fell to new lows (for many, all-time lows), and the Chicago PMI plunged. Credit conditions continued to improve, but remain above pre-Lehman levels, as is overall market volatility. With financial market conditions still at stressed-out levels and economic outlooks eroding rapidly, it would be premature to suggest that further bouts of panic won't still materialize. However, the stabilization seen in this final week of October does favor a more prolonged period of consolidation as markets get their feet back under them.

In FX, the USD looks to have made a significant high, which was followed by a sharp retreat as global stocks recovered. The USD pullback was extremely short-lived, however, and we are ending the week with the USD still above key support levels. Month-end USD buying demand was most likely behind the late-week rebound in the USD, and we will be watching closely to see how the USD fares once such buying is no longer present. On the other side of the coin, impending interest rate cuts from Australia, Europe, and the UK (see below) provide significant headwinds to those currencies in the immediate future. As well, the US election (see below) offers a potential boost to the USD depending on the outcome. On balance, I would tend to favor trading the USD from the long side in the week ahead. Carry trades, however, are closing the week above key supports on Ichimoku charts, and this fits with a potential stabilization/rebound in risk appetites. For the JPY crosses, I would also favor trading them from the long side. These views are somewhat conflicting, but the net result may be an outsized gain in USD/JPY offsetting declines in EUR/USD, GBP/USD, and AUD/USD, leaving the JPY crosses higher on the week. USD/JPY remains range-bound while between 96.50/99.00, but a daily close above 99.00 would target additional gains back to 102.50 initially, with further potential up to the 105/106 area. In EUR/USD, the 1.2720/50 level remains the pivot between the upper and lower ends of what may potentially develop into a 1.23/1.33 consolidation range.

US Election and the Impact on the USD

On Tuesday, Nov. 4, the US presidential election will finally take place. Results are not expected to be called before polls close on the US west coast, suggesting no decision until after 2300ET/0400GMT. (NB: US clocks will be set back one hour on Sunday morning as daylight savings time ends.) Most polls point to a victory for the Democratic ticket (Obama/Biden), and that would be our expectation going into Tuesday. We think the USD would benefit from an Obama victory, potentially significantly (e.g. EUR/USD below 1.20, USD/JPY over 102.50, given his popularity abroad and what would be seen as a clean shift away from the policies of the current administration. A McCain victory, on the other hand, would likely see the USD slump, as another Republican administration may be negatively embraced by markets. But as we have seen in recent US elections, polls cannot be taken for granted. Also, there is significant potential for legal disputes to delay the finalization of the election result, especially in such closely contested states as Ohio and Florida. We would view another disputed election result as a negative for the USD and risky assets, given that markets are craving order and stability like never before.

RBA, BOE, and ECB Rate Decisions Next Week

The RBA, BOE, and ECB will be making their rate decisions next week. Here is how we expect these events to play out.

The Reserve Bank of Australia is up first on Tuesday at 0330GMT. The market is looking for the bank to reduce rates by -50 bps on top of the -100 bp unscheduled cut in early October. Commodities, which are central to the Australian economy, continued to decline, and fell a whopping -24% in the month of October. The continued slowing in global growth has the potential to push commodity prices even lower as we head into 2009. Given this looming risk, we believe the bank will be proactive in cutting interest rates in order to stimulate the economy. However, with inflation still seemingly a problem, the current forecasts for a terminal rate of 4.5% by the middle of next year are likely too optimistic. We expect that the market reaction from a -50 bps cut will be to sell AUD initially, only to see a reversal shortly thereafter. Should the RBA decide to frontload the cuts and slash rates by a more aggressive -75 or -100 bps, then the selling in AUD would be more intense, and in this case, sustained.

The Bank of England is set to meet on Thursday and announce rates at 1200GMT. The consensus is for a -50 bp cut in rates to 4.00%, but this is quite contentious. Several economists predict that the BOE will be more aggressive and cut rates -75 bps, while others are looking for an even sharper -100 bp reduction. There is no question that economic activity has deteriorated, with some BOE members going as far as acknowledging that the UK is in recession well into 2009. The divergent estimates suggest that the price action around this rate cut should be quite volatile. If the bank cuts -50 bps, we would likely see an initial GBP selloff and then a reversal to higher levels. Short sellers who were expecting a more aggressive cut would likely get squeezed out here. The latter scenario of a -75 or -100 bp move would see sharp selling of GBP without much reprieve.

Last but not least, the European Central Bank is scheduled to meet on Thursday and announce rates at 1245GMT. The consensus is unanimous in expecting a -50 bp reduction to 3.25%, and the futures market is priced for a cut of that magnitude as well. The rate cut itself is likely to be a non-event unless the ECB surprises markets with a lower than expected cut of say -25 bps. The subsequent press conference from ECB president Trichet at 1330GMT will likely garner most of the attention. Trichet is expected to acknowledge the continued deterioration in EU economic fundamentals, while likely giving some lip service to the risks of inflation. The ECB is hard pressed to make an argument on intensifying inflation risks, but given that price stability is their one and only mandate, they will probably continue to harp on it. The implications for EUR from the rate cut and press statement are likely to be negative. While a -25 bp cut, with all else equal, would typically see EUR higher, this time it could be viewed as a complacent move by the ECB in an environment of quickly deteriorating growth, likely leading EUR/USD to reverse any gains and head lower.

Key Data and Events to Watch Next Week

The US data calendar is busy next week, with a ton of top-tier numbers on deck. Monday kicks things off with ISM manufacturing, construction spending, and motor vehicle sales. Tuesday is light with just factory orders, while Wednesday sees ADP employment and weekly crude oil inventories. On Thursday, we get productivity, unit labor costs, and the usual weekly jobless claims data. Friday rounds out the week with a bang as we have the employment report on tap. This will be followed by wholesale inventories, pending home sales, and consumer credit. There are a couple of Fed speakers lined up next week as well, with Lacker on Monday, Fisher on Tuesday, and Warsh and Lockhart on Friday.

It is a pretty eventful week in the euro zone as well, and Monday starts it off with PMI manufacturing and the European Commission's economic growth forecasts. Tuesday is light, with only producer prices on tap. Wednesday sees services PMIs and euro zone retail sales. Thursday has German factory orders and the key ECB rate decision (more on this above). Friday closes out the week with German trade, French trade, and German industrial production.

By Brian Dolan of

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