Explaining the dollar’s new low yielding status
We received several comments and inquiries related to our statement late last week indicating the dollar’s new status as a low yielding currency and, hence a carry trade candidate. Despite the dollar’s absolute rate advantage over some currencies (CAN, JPY and CHF), it is the expectations of further currency losses that is expected to erode the remaining rate differential. The fact that the U.S. Federal Reserver funds rate, now at 4.75%, is higher than its counterpart in Canada (4.50%), Euro zone (4.00%), Japan (0.50%) and Switzerland (2.75%), the anticipated reduction – and erosion – of the U.S. yield advantage is the main driver of the dollar’s deepening losses, which outweigh the current yield advantage of the dollar over these currencies. A 25-basis point Fed cut this week will bring U.S. rates to the same level as Canada for the first time since February 2005 and reduce the dollar’s yield advantage over that of the Euro zone to the lowest level since February 2005. Thus, FX carry trades not only thrive on the anticipated reduction in a nation’s interest rate vis-à-vis other nations, but also in the resulting decline in the value of that currency ahead of further rate reductions.
The onset for prolonged Fed rate cuts is similarly matched by the likelihood of non-U.S. interest rates remaining unchanged, or even rising in the short-term, as is the case of Australia. The unwinding in U.S. housing continues unabated from a perspective of falling prices, falling sales of new and existing homes, increased months’ supply and falling construction jobs. Today’s latest advance in gold to a fresh 28-year high (January 1980) of $798 per ounce at the NY Comex is clearly a manifestation of the deteriorating dollar fundamentals and outlook. Indeed, soaring gold prices have also been driven by falling production (lowest in 10 years), slower rate of selling by global central banks and record high interest by purchases of ETFs and futures contracts.
Why we expect the Fed to go 25-bps? We expect the Fed to cut the Fed funds rate by 25-bps to 4.50% and the discount rate by 50-bps to 4.75% due to the following:
The Fed needs to keep its powder dry ahead of further deterioration in housing (which so far has eluded the Fed’s forecasts). Aggressive rate cuts this year could subject the dollar to accelerating selling pressure by central banks, prompting a run on the currency and threaten the foreign financing of the current account deficit. Rapid declines in short-term rates would also mean excessive steepness in the U.S. yield curve as long-term yields push higher on reduced demand for long-term Treasuries.
Other arguments for not expecting a half point move is the relatively lofty levels in U.S. stocks. The S&P 500 is currently 4% higher than it was on Sept. 18 before the FOMC announcement. There is also more stability in the LIBO and CP market.
The Fed will want to wait and see the latest data on payrolls, ISM reports and as well consumer spending data before committing to a more aggressive move. Thursday’s release of September consumer spending is expected up 0.4% from 0.6%, while the October manufacturing ISM (also Thurs) is seen at 51.6 from 52. Our preliminary forecast for the October payrolls is at 90,000 from 110,000 with the unemployment rate up at 4.8% from 4.7%. While these figures suggest weakness, they do not warrant an aggressive Fed move that is more typical of emergency measures.
A quarter-point move is expected to be negative for equities and the dollar, as the combination of risk aversion and anticipation of further rate cuts dictate the action in stocks and equities.
EUR/USD eyes 1.4350 on pre-Fed profit taking Hovering at $1.44, EUR/USD has retreated from its latest all time high of 1.4437 amid habitual profit taking ahead of an uncertain Fed meeting. A prolonged sell-off in U.S. equities resulting from a 25-bp cut may cap the euro’s gains in the event that traders reason that the U.S. slowdown will extend to the Euro zone and forcing the European Central Bank (ECB) to remain on hold throughout next year. But we deem such declines in the euro as largely temporary and corrective in nature due to the considerable real money demand from central banks, sovereign wealth funds and other institutional players altering their asset allocation ahead of year-end. Interim support stands at 1.4380, followed by trendline support at 1.4350, which is also held by the 38% retracement of the move from the 1.4220 low. Upside capped at 1.4430, followed by 1.4470.
USD/JPY capped at 115, Moody’s downgrade, UBS announcement loom USD/JPY continues to act as the sole anchor of support for the U.S. currency amid the absence of risk aversion in global equities. The latest surge in USD/JPY in the past 30 minutes trade is taking place on overall profit taking, which is helping the dollar stabilize across the board.
We do warn renewed declines in USD/JPY and other yen crosses as well as unwinding of high yielders as Moody's heads off a new wave of credit downgrades of mortgage-backed securities. Recall the sharp declines in USD/JPY when Moody’s began downgrading over $50 billion in mortgage-backed securities three months ago. The credit rating agency is now expected to resume downgrading securities linked to those previous assets. The announcement from UBS warning of prolonged subprime losses after having already warned of losses in Q3 is also expected to weigh on risk appetite. We expect USD/JPY to extend gains towards 114.90, at which point will face pressure at 115, which is the 38% retracement of the 117.93-113.22 move. Support starts at 114.40, followed by 114.00.
Sterling breaks $2.06 Sterling’ breaks above the $2.06 for the first time since July largely on dollar weakness play. But rising risk appetite is also propping sterling against the yen and Swiss franc. We continue to recommend cautiousness with sterling as excessive risk appetite implies the threat of a sharp correction ahead, especially considering latest evidence of slowing housing and next week’s Bank of England inflation report. Last week’s forecast by the National Institute of Economic and Social Research, expecting a slowdown in 2008 gross domestic product (GDP) growth to 2.2% from 3.1% in 2007 should also be taken to notice. Upside capped at $2.0640, followed by 2.0660. Support stands at 2.0550.
Aussie shatters 92¢ to 92.70, highest in 23 years. Our bullish case for the Australian dollar remains underpinned by the currency’s prowess to rebound rapidly following bouts of risk aversion. Aussie’s rally in gold terms reflects the secular improvement of fundamentals in the currency and expectations for an RBA rate hike next week. Aussie hit a new high at 92.70¢, while extending gains across the board versus the euro, sterling and yen. Profit taking is taking place during the writing of the report, with pullback towards at 92.17¢ as gold is dragged to $788 from its $798 high earlier today. The risk of renewed equity volatility continues to be seen as a medium-term buying opportunity, considering the resulting decline in the pair and subsequent rebounds thereafter. Support seen limited at 92¢, but a decline below the figure is seen standing at 91.60. Prolonged gains seen targeting 92.50, followed by 92.85.
Ashraf Laidi Chief FX Analyst CMC Markets US a.laidi@cmcmarkets.com
