Now that many members of the financial market community, traders and media have realized that the Federal Open Market Committee (FOMC) statement was not an abandonment of the tightening bias, in fact Fed was more hawkish on inflation this time around, the market is having another go at the reaction. The Fed's dovish take on growth and housing was a move into neutrality but not an abandonment of the tightening bias.
The dollar extends gains across the board, in line with our morning piece calling for a decline in EUR/USD and GBP/USD to 1.3340 and a 1.9620 respectively. Apart from the post FOMC reevaluation resulting from traders overlooking the Fed’s continued the inflation vigilance remarks from German think tank IFO urging the European Central Bank (ECB) to refrain from further rate hikes, is contributing to the euro’s pullback. With the four-hour MACDs suggesting 1.3336—the 23.6% retracement of the 1.3091-1.3412, this could open the way for 1.33 trendline support.
Expect further declines in GBP/USD amid Wednesday’s surprisingly dovish minutes from the Bank of England (BOE). Sterling bulls barely had the chance to cheer the higher than expected 2.7% consumer price index (CPI) before the BOE minutes stood in the way. Expect prolonged cable losses towards 1.9620 to stabilize at 0.96. This calls for further run-up in EUR/GBP towards 68 pence followed by 68.30.
Wary of the potential repercussions of renewed accelerating yen strength from the Fed’s dovish shift, Japanese policymakers are reiterating their willingness to provide policy accommodation. This could be interpreted to mean that BoJ will not raise rates soon, but what we think it really means is that the bank attempts to prevent any destabilizing jump in the currency, that would complicate the central bank’s path to gradual tightening.
Breaking above the 200-day moving average, USD/JPY should encounter resistance at 118.33 high –50% retracement of the 121.67-115.09 decline. Subsequent pullback stands at 118.50. Focus turns to tomorrow’s U.S. existing home sales, which should be more momentous in the event of unexpected weakness and place the Fed's housing downgrade in greater perspective. We see this as an opportunity for renewed yen longs amid the next data disappointment from the United States.
Despite the bounce in yields at the movement, the chart below shows that a continuation of the normalization of the U.S. yield curve should help cap the U.S. dollar. Historically, the yield inversion has been positively correlated with escalating yen shorts against the U.S. dollar as well as the decline in the currency.
Yield curve normalizes as Fed neutralizes
There has been no dollar reaction to the lower-than-expected weekly jobless claims release, which showed a drop to 316,000, undershooting expectations of 323,000 from 320,000.
Markets realize it was an overreaction The dollar rebounds off its post-Federal Open market Committee (FOMC) lows as traders reevaluate the excessive selling in the U.S. currency based on what we deemed was an overreaction to the FOMC statement. Although the Fed discreetly toned down its view of recent data and downgraded its assessment of the U.S. housing market, the inflation vigilance remained largely intact.
Fed lifts foot off brake, but away from gas pedal The Fed’s replacement of the phrase “additional firming” with “Future policy adjustments” does not constitute an explicit abandonment of the tightening bias because of the maintenance of the inflation vigilance, which in fact was stepped up from the January statement. Replacing the inflation reference, which stated, “improved modestly” by “somewhat elevated” is a continuation of the Fed’s vigilance of price pressures. For this, we deem the statement as a subtle move to neutrality, with a touch of inflation concern.
Fed does not have to signal easing bias before cut While it is preferable that the Fed signals its shift towards an easing directive, it has shown in the past that it could move directly from neutral bias to an actual rate cut. This was proven in the January 2001 rate cut, which was the first reduction of the 2 ½ year easing cycle. The fact that there is no FOMC meeting in April could see the Fed move towards a May cut in the event of a deterioration in market and economic conditions, accompanied with two consecutive monthly increases in the unemployment rate (March and April rates to be released next week and just before the May FOMC meeting).
Normalization of yield curve opens way for May rate cut The normalization of the yield curve signaled by 10-year yields matching (and briefly rising above) two-year yields reflects the bond market’s gradual shift towards expecting a 2007 easing. The 10-year/two-year yield spread became positive during the stock markets sell-off and surge in volatility between April and May of last year before turning negative again. Further increase in 10-year yields above their two-year counterpart would signal an increase in bond markets’ expectation for Fed easing. This will largely depend on the incoming data and especially the Federal Reserve speeches in April.
Our expectations since December for a second quarter Fed easing remain intact. We lift probabilities of a May rate cut to 75%, with the 2007 easing expected to be an aggregate of 75 bps to 4.50%.
The 10 am EST release of the February index of leading economic indicators is expected to show a drop of 0.4% following 0.1% and 0.6% in Jan and Dec respectively.
Yen drops as BoJ makes its own dovishness
Remarks from Bank of Japan governor Fukui indicating continued accommodation of policy conditions placed renewed downward pressure on the yen, lifting USD/JPY to a 117.91 high from the 117.27 post- FOMC low. It may not be a coincidence that Fukui uttered these dovish remarks hours after the Fed’s own dovish statement to prevent any appreciable increase in the currency.
Traders remain mindful of the 200-day moving average at 118.04, a break of which is only possible in the event of an unexpected increase in this morning’s leading economic indicators index. But with the LEI expected to dip by 0.4%, it is likely to keep the pair capped below 118. Profit taking in U.S. stocks should help the pair drag towards 117.50 and 117.20. A break of 118.10 is seen capped at 118.30.
Euro short-term chart suggests 1.3340
After surging to a two-year high of 1.3411 yesterday, EUR/USD pulls back on a revaluation of market’s reaction to the FOMC. Remarks from German think tank IFO urging the ECB refrain from further rate hikes is also contributing to the pullback.
Four-hour MACDs suggest 1.3336—the 23.6% retracement of the 1.3091-1.3412 rise Subsequent support stands at the 1.33 trend line support. Upside capped at 1.3390, followed by 1.3430.
Cable profit-taking vulnerable to 1.9620 Wednesday’s surprisingly dovish minutes from the Bank of England showing not only there were no members calling for a rate hike this month, but that one member, David Blanchflower, calling for a quarter point cut, should help cap sterling, and make it an attractive short against the yen and the Canadian dollar.
Cable seen testing 1.9650, followed by 1.9620 and 1.96. Downside surprise in the U.S. LEI should help the pair regain 1.9700, but we do not foresee a breach of the 1.9730. The fact that sterling’s gains were largely on the back of the dovish Fed make the currency vulnerable to the next upside surprise in the U.S. data, or downside surprise from the Euro zone.
Ashraf Laidi Chief FX Analyst CMC Markets US 140 Broadway, 30th Floor New York, NY 10005 (212) 644-4220
(212) 644-4222
a.laidi@cmcmarkets.com
