Markets Are Given a Reprieve…For Now

12/01/2008 10:23 am EST

Focus: STOCKS

Brian Dolan

Chief Currency Strategist, FOREX.com

Financial markets were thrown a lifeline when the Fed stepped in to guarantee troubled assets of a major US bank and initiated yet another lending facility to stimulate business and consumer lending. Promises of additional fiscal stimulus from the incoming Obama administration added further fuel to the rally, and global stock markets rebounded in major fashion, erasing the devastating losses of the prior week. Risk appetites recovered in tandem, and this saw the USD sold off and the JPY crosses rally strongly. By the end of the week, stocks had maintained their gains, but the JPY crosses had surrendered nearly all of the gains for the week, leaving the outlook for risk appetites highly uncertain. It seems that without recurring government initiatives, markets are unable to sustain rallies, which is to be expected given the unfolding global recession. Adding to the confused sentiment, Friday's strong recovery in the USD was driven by month-end USD fixing demand from asset managers, as well as increases in inter-bank lending rates, which saw USD LIBOR rise above the Fed's target rate for the first time in a month. While most likely due to month-end distortions, the USD recovery and the deterioration in credit market conditions suggests we still have a long way to go before sentiment is stabilized.

The coming week is expected to see stocks attempt to extend this week's gains, and currencies remain likely to take the lead from shares yet again. The S&P 500 is set to close the week above key trend line resistance at 875 that guided the move lower since mid-September. We would view a daily close above the 890/900 level as a good indication that market sentiment is improving further, and this would see the USD turn lower and JPY crosses higher. In EUR/USD, we are watching the 1.2750/2800 level as the pivot between strength and weakness, with potential back down to 1.2450/2500 while below, and room up to 1.30050/3100 if above. In GBP/USD, the recovery higher remains in place while above the 1.5100/50 area, and strength above 1.5600/50 could see a recovery toward the 1.6000 area in the near term. Expected interest rate cuts by key central banks (see below) could provide the catalyst for further recovery in sentiment, but the risk is that markets relapse even with substantial interest rate relief.

Central Bank Rate Decisions: RBA, RBNZ, BOE, and ECB

Next week sees interest rate decisions out of Europe and the Antipodes. Below is a recap of market expectations and our outlook for potential market reactions.

Australia - The RBA is first up on Tuesday afternoon local Aussie time (2230ET Monday night/0330GMT Tuesday morning) and the market expectation is for a 75 bp rate cut from 5.25% to 4.50%. We would look for initial AUD weakness to give way to an eventual rebound, especially if the RBA decides to move more aggressively and cut by 100 bps.

New Zealand - The RBNZ will announce on Thursday morning local Kiwi time (1500ET Wednesday afternoon/2000GMT Wed. night) and the consensus looks for rates to be slashed 150 bps from 6.50% to 5.00%. We would look for NZD to remain under pressure after the rate cut due to the more serious economic decline in NZ and the likelihood of further rate cuts still to come.

UK - The BOE announces at 0700ET Thursday morning/1200GMT and the view is for a 100 bp rate cut from 3.00% to 2.00%. The risk is that the BOE, facing a severe downturn, acts more aggressively and delivers a second 150 bps of easing in a row. GBP would likely be disappointed with anything less than 100 bps, as it would suggest a more drawn out downturn, while a more proactive cut of 100+ bps would likely see GBP benefit.

Euro zone - The ECB will announce at 0745ET Thursday morning/1245GMT and the market is expecting only a 50 bps rate cut from 3.25% to 2.75%. Given recent comments from Trichet and arch-hawk Weber that inflation pressures have abated significantly and give the ECB "ample" room to move, the risk is that the ECB turns more proactive and cuts by 75 bps. Such a move would likely see EUR perform better as the ECB would finally signal that it "gets it" and is prepared to accommodate in light of eroding outlooks. Only 50 bps of easing would probably hurt EUR in the short run, while subsequent comments from Trichet indicating additional future rate cuts may then stabilize EUR sentiment.

By Brian Dolan of Forex.com

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