How Will A Rate Cut And Recession Effect The Dollar's Reserve Status?
Risk aversion has dominated all markets; and the demand for liquidity and security has sent panicked investors to the US dollar. However, with the world’s largest economy wading slowly into a recession and interest rate speculation pointing towards the lowest returns from US assets in history, how long can the greenback’s rally last?
How Will A Rate Cut And Recession Affect The Dollar’s Reserve Status?
Fundamental Outlook for US Dollar: Bearish
- Federal Reserve adds another layer to its bailout plan with $540 billion to stabilize money market funds
- Risk appetite continues to deflate as recession fears and deleveraging stoke fear
- Bernanke tells Congress in testimony the US economy is in a “serious slowdown”
Risk aversion has dominated all markets; and the demand for liquidity and security has sent panicked investors to the US dollar. However, with the world’s largest economy wading slowly into a recession and interest rate speculation pointing towards the lowest returns from US assets in history, how long can the greenback’s rally last? There are two major considerations for how far the dollar’s rally may go: the general level of risk sentiment and the health of the health of the US economy. Before market participants ever concern themselves with returns and the level of interest rates, fear must be stemmed. Panic has overwhelmed the market such that liquidity and safety of funds are the only concerns for capital allocation. This sense of preservation has evolved with time, starting with bank defaults, going on to a credit crunch and then to massive capital losses through the ensuing market crashes.
However, through this process, the true driver behind the declines eventually came to light: leverage. Investors, banks, lenders and even consumers around the world had steadily leveraged themselves on credit since the markets recovered from the bursting of the Dot Com bubble. In the bull market, banks created derivative products to make returns of 30-plus percent, lenders relaxed their conditions and ran down reserves, and consumers drove up their credit bills to record levels to purchase goods. Now, the house of cards has come crashing down; and everyone is demanding their money back. The problem is that the losses that are being incurred have been multiplied by the leverage and is subsequently overwhelming the initial capital that originally supported the deals and investment. Now with margin calls, defaults and illiquid markets, a long line is forming to unwind positions; and the market must deleverage or face catastrophic defaults. This means that all the world’s governments can do is ease the pain – and not stem the tide. Boosting confidence in counterparties, guaranteeing lending and steadying the natural drop in asset values is all the that officials can do.
And, while the market will not likely see the end of its deleveraging next week, we can still see the dollar reverse should confidence in its safe haven status be shaken. There are two major events scheduled for the week that may sour the greenback’s rally. The first release is the Federal Reserve’s rate decision on October 29th. Economists expect a 25bp cut to 1.25 percent; but the market has already priced in a 100 percent probability of a 50bp cut and even a 25 percent chance that the policy board will take the benchmark rate all the way down to 0.75 percent. The central bankers will need to consider whether such a move would even help (as previous easing hasn’t yielded the intended effects with banks not passing on the savings) and if it will instead just invite more problems when the global economy actually recovers. The other prominent event is the follow day’s advanced reading of 3Q GDP. There is little doubt that the US is already one foot into a recession (we need two quarters of contractions for a technical recession), but the long-term strength of the dollar going forward will depend on how shallow the nation’s recession is and how quickly it recovers relative to its global counterparts. – JK
Euro Economic Outlook Is Bleak, But Currency May Still Gain This Week
After falling nearly 6 percent last week and testing critical support at 1.2500, many are hoping that EURUSD will finally turn higher soon. However, Euro-zone economic releases will be working against that as nearly every report is forecasted to deteriorate.
Euro Economic Outlook Is Bleak, But Currency May Still Gain This Week
Fundamental Outlook for Euro: Bearish
- IMF forecasts more European banks could fail as recovery is not expected until late 2009
- FXCM SSI shows that EURUSD positioning flipped to net short last week – reversal potential?
- Euro-zone services, manufacturing PMI holds below 50, signaling contraction, for fifth straight month
After falling nearly 6 percent last week and testing critical support at 1.2500, many are hoping that EURUSD will finally turn higher soon. However, Euro-zone economic releases will be working against that as nearly every report is forecasted to deteriorate. First, Germany investor and consumer sentiment as measured by IFO and GfK, respectively, is anticipated to slip in light of the worsening credit market conditions, indications of recession in the region, and mounting job losses. Likewise, retail sales are expected to fall negative as domestic demand wanes. However, the release of Eurostat’s estimate of Euro-zone CPI may have a bit more market-moving potential, as the index is likely to show that inflation growth eased to a 3.2 percent pace in October from 3.6 percent. Given European Central Bank President Jean-Claude Trichet’s more bearish stance on economic growth and the bank’s participation in the October 8 coordinated rate cuts, a weaker-than-expected CPI reading could exacerbate the market’s speculation that the central bank will cut rates again soon. We also have to consider that the Euro-zone unemployment rate will also be released at the same time and is forecasted to hold steady at 7.5 percent. Given the dismal conditions plaguing the region’s economies, there is a risk that the unemployment rate will tick higher, and combined with a drop in CPI, the euro could easily plunge.
However, the forex markets have brushed off most economic releases over the past few weeks as risk appetite has become the primary driver of price action. As a result, if we see that investor sentiment improves a bit and risky assets like oil start to gain, especially in light of OPEC’s 1.5 million barrel per day output cut last week, EURUSD could finally recover, or at the very least, hold above near-term support at 1.2500. – TB
British Pound Dives On UK Recession News - Rebound Potential?
After seeing its biggest intraday decline in at least 37 years amidst recessionary UK GDP figures on October 24, the British pound has potential to rebound somewhat this week, but economic data may not play much of a role in that.
British Pound Dives On
Fundamental Outlook for British Pound: Bearish
- BOE October meeting minutes show unanimous vote for 50bp cut, raises risks for more on November 6
- UK retail sales slump as rising unemployment, tight credit conditions weigh on consumption
- UK Q3 GDP confirms recession fears – GBP sees biggest intraday decline in at least 37 years
After seeing its biggest intraday decline in at least 37 years amidst recessionary UK GDP figures on October 24, the British pound has potential to rebound somewhat this week, but economic data may not play much of a role in that. Indeed, given the 0.5 percent drop in Q3 GDP, which confirmed a contraction in the economy, speculation has increased that the Bank of England will cut rates by at least 50bp at their next meeting on November 6, if not by 100bps. With Credit Suisse overnight index swaps pricing in nearly 200bps worth of rate cuts over the next 12 months, an aggressive reduction next month doesn’t seem out of the question. However, according to Technical Strategist Jamie Saettele, last week’s ATR reading for GBP/USD was one of the largest ever. With ATR’s of similar magnitude leading to significant turns in the 1990’s and earlier this decade, the moves suggest that it may be time to start looking for indications of a bottom in the pair.
Data-wise, things are likely to remain bleak in the UK. In fact, Nationwide house prices are forecasted to fall negative for the twelfth consecutive month as the housing collapse continues while mortgage approvals are likely to reflect similar sentiment. Meanwhile, CBI Distributive Trades may reveal negative sales yet again, especially since PMI manufacturing for the UK has held below 50 (signaling contraction) for five consecutive months. Finally, GfK consumer confidence is forecasted to slip to -36 from -32 amidst the financial market crisis and economic slowdown. Overall though, price action over the past few weeks has shown that fundamentals aren’t playing a huge role in the currency markets unless there is a significant release like GDP. Since that risk looms on the US side of the equation, GBP/USD could finally see a bit of a reversal this week, barring something completely unexpected like an inter-meeting BOE rate cut.
Japanese Yen Will Hold Its Gains As Long As Risk Dominates
Following on a volatile end to an incredibly strong week, Japanese yen traders’ first thought upon the return of liquidity after the weekend should be ‘what is the level of risk sentiment in the market?’ Should the world’s policy makers proffer another coordinated effort to encourage calm in the markets, an overextended yen could see a sharp pull back as general risk appetite finds its way to a relief rally.
Japanese Yen Will Hold Its Gains As Long As Risk Dominates
Fundamental Outlook for Japanese Yen: Bullish
- Fears arise that emerging markets may begin to default on sovereign debt, adding fuel to the fire
- Data confirming a global recession is sweeping over the market
- Government bailouts and unlimited short-term funding can’t curb the market’s need to deleverage
Following on a volatile end to an incredibly strong week, Japanese yen traders’ first thought upon the return of liquidity after the weekend should be ‘what is the level of risk sentiment in the market?’ Should the world’s policy makers proffer another coordinated effort to encourage calm in the markets, an overextended yen could see a sharp pull back as general risk appetite finds its way to a relief rally. Beyond a temporary pull back in fear, fundamental interest in the Japanese currency will take its lead from the ongoing drop in investor sentiment and capital markets. While the trillions of dollars of losses in asset value across the markets this past month has leveraged the demand for the yen, there is more of a fundamental basis for the currency’s appreciation than mere panic. Beyond the multi-year lows and record breaking declines of the world’s premiere share indices, all market participants are merely trying to deleverage from massive positions that are quickly taking on water. In the currency world, no where was leverage more abused than in the carry trade.
What’s more, even should carry interest peter out (which it won’t), capital will continue to flow into Japan as it represents one of the most fiscally sound nation’s in the world and the second largest economy – therein a safe place to harbor capital. As the global economy further tips into a recession, traders will further reassess where to place their funds. Next week, the US is expected to follow the UK by confirming a contraction in economic activity through the third quarter. While the dollar will nonetheless retain its safe haven status, confidence will still be marred in the US dollar. Subsequently, number two Japan will seem a good place to diversify, just in case.
The only scheduled economic data on the Japanese docket in the week ahead with any sort of tout is, oddly enough, the Bank of Japan’s rate decision. The central bank hasn’t cut rates since 2001 and the benchmark has held at or below 50 basis points for thirteen years now; but a shift from policy makers now would suggest they are running out of options. The BoJ essentially has no capacity to revive the markets through traditional monetary policy means – the same situation they were in following the 1997/1998 financial crisis. From a primary lending rate of 0.50bps, they could cut very little; and even at zero (ZIRP), we have seen that the economy and investment trends have suffered even during the best of global economic conditions. This will be a very important contingent to watch going forward to gauge the long-term strength of Japan, its assets and its currency. - JK
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