This is a special note on current market conditions and the FX implications
The current market turmoil is triggering classic flight to quality, sending flows into bonds and low yielding currencies such as the yen and Swiss franc, and away from the high yielding currencies such as the Aussie and Kiwi. The fact that the world’s major central banks are obligated to intervene with special liquidity injecting operations during an inflationary environment qualifies the situation as a crisis. For regular readers of our daily FX strategy, these events should be of no surprise. Here are a few warnings from the past:
What we said on July 17
Surging liquidity and rising inflation pressures were seen as factors that countered the arguments for Fed rate cut. But as we repeatedly mentioned in past reports, the risk of market contagion weighing on capital market liquidity and the broadening economic weakness capping overall inflation, the Federal Reserve will have to act as early as the fourth quarter. A renewed rally in gold prices is anticipated to be accompanied by broad rebound in the Japanese yen, which has proven to be the best performer against gold prices in the past six business days (up 3.6%). As a result, we see a brief reprieve in the U.S. dollar against EUR, GBP, AUD, NZD and CAD, but to resume its general declining trend against the yen.
What we said on July 27
Our case for a 2007 interest rate cut throughout this year has been capital market-oriented as well as macro-oriented. The capital market rationale is highlighted by reduced risk appetite affecting liquidity in a highly leveraged financial landscape, which spells the probability of contagion. The risk of such contagion could occur via the following: 1) A sharp rebound in the yen would jeopardize billions of dollars worth of what were initially low cost yen loans 2) Higher interest rates on U.S. mortgage owners after interest rate resets; 3) Deterioration in the values of subprime securities as these are unloaded.
The dollar may not recover as in past market crisis
The ensuing dollar rally is partly due to a reversal of unwinding in carry trades, whose flows were not only boosting high yielding FX at the expense of the yen and the franc, but also boosting euros, gold and even oil futures. The other reason for the dollar decline is the flight of quality to U.S. treasuries, whose yields have plunged by 16 basis points in two days.
The current market crisis bears more damaging consequences for the U.S. dollar than the collapse of Long Term Capital Management (LTCP) in 1998, whose repercussions revolved mostly around emerging markets. The LTCM collapse occurred mainly due to soaring yields in sovereign bonds of Russia and Brazil, which bore similar as far as dollar assets are concerned – a massive flight of quality to the U.S. treasuries along with a sharp slide in USD/JPY.
Thus, unlike 1998 when the U.S. economy grew 4.7% in Q3 and 6.2% in Q4, and the Fed’s emergency rate cuts were only directed at shoring up liquidity in a handful of banks, today’s U.S. economy is growing at a sub par pace of 2.0%, with housing and manufacturing recessions threatening to disrupt an increasingly fragile consumer fabric especially with oil prices and gasoline prices 320% and 200% greater than in 1998 respectively.
The dollar may even extend some of its gains versus the euro and sterling as the European Central Bank (ECB) and Bank of England (BoE) may delay their intended rate hikes. Nonetheless, it is important to recall remember the state of the macro dynamics in the United States before the current market fallout, which stood in contrast to that of the United Kingdom and Euro zone. The medium to long-term outlook for the dollar remains saddled by a deterioration in the dynamics that were already struggling before the current market crisis, such as continued decline in home prices, home sales, building permits, slowing job market (13th straight month in manufacturing job losses, falling construction jobs, falling retail jobs and even a sharp slowdown in job creation of services, education leisure/hospitality all lowest since September 2006).
Yesterday’s $19 billion liquidity pump by the Federal Reserve Bank was the equivalent rate cut of more than 65 basis points, as the cash market Fed Funds rate soared to 6.00% from its benchmark target of 5.25%. This morning the NY Fed issued a note to assure banks they have open access to the discount window. The effect of the announcement and similar announcements (and operations) anticipated has a temporary effect in relieving the declines in high-yielding currencies, rise in yen and sell-off in equities.
But the expected economic repercussions on further pullback in housing prices and construction as well as housing related jobs (mortgage brokers, residential and commercial construction) and escalating foreclosures and delinquencies will likely exacerbate the capital return element of homeowners as well as income producing sources of these housing related jobs.
The other major threat to the U.S. economy is that from falling stocks on personal expenditure. We already saw a decline in personal consumption expenditure in Q2 to 1.3% from 3.7% in Q4, the lowest since Q4 2005. When stocks fell more than 7% in Q2 2006, PCE growth slowed to 2.4%, a 45% decline. Today, with stocks down 7% in the first half of the quarter alone, the probability of PCE growth to come in flat are significant, and so are chances of a flat Q3 GDP.
USD/JPY: USD/JPY broke below its 100-day moving average of 117.56 to a 4 1/2 month high of 117.16, in line with our expectations for a larger move lower, targeting 116 by month end. Meanwhile, we may see declines to as low as 115.60, which is a major trend line support from the 2005 low. Interim gains remain corrective in nature, with resistance at 118.30 and 118.80.
EUR/USD: Support remains the level mentioned in last week’s pre-holiday report at 1.3630, which is just above the 38% retracement of the 1.3262-1.3852 move. Further damage may occur if the ECB moves away from its restrictive policy, where support is seen holding at 1.3590. We expect renewed recovery once the dust clears from Euro zone capital and loan markets, for an objective of 1.39 before Q3 end.
GBP/USD: Cable’s inverse correlation with the yen and positive relation with equities remains notably high, as is the case of USD/JPY, GBP/JPY, NZD/USD, NZD/GBP and AUD/USD. The Bank of England’s inflation report may provide renewed fuel upon stability in the markets, but the nearing of the tightening campaign allows for limited gains at $2.028 and $2.0340. We expect further pullback towards 2.0140 followed by 2.0050.
Ashraf Laidi
Chief FX Analyst
CMC Markets US
140 Broadway, 30th Floor
New York, NY
(212) 644-4220
a.laidi@cmcmarkets.com
