The sharp decline in U.S. treasury yields simultaneous with further steepening in the yield curve (measured by the difference between 10 and two-year yields) reflects the aggressive pricing of further Fed rate cuts, which is weighing on the dollar. Following the Fed’s publication of downward revisions in its growth and inflation and projections along with upward revisions in unemployment, bond and currency markets have quickly reflected those expectations in yields and the dollar, while equity markets continue to tumble on the latest confirmation of increased downside risks in the U.S. economy. U.S. 10- year yields dropped 11-basis points to below 4% for the first time in more than two years, two-year yields fell 12-basis points to 3.06%. Consequently, the difference between 10-year and two-year yields has now risen to 93-bps, its highest since January 2005. The widening spread is a measure of the steepening U.S. yield curve, which is consistent with further rate cuts. With the spread rising from 54-bps at the last Federal Open Market Committee rate cut three weeks ago, the latest developments suggest more than an 80% probability of a 25-basis point rate cut next month. Looking at the historical pattern between yield curves and Fed easing, we expect the 10-year/two-year spread to rise by at least another 50-bps to 140-bps, which will be equivalent to 75-bps further in interest rate cuts.
This morning’s U.S. releases on weekly jobless claims, consumer confidence and Leading Indicators index will be carefully monitored as they may serve as a confirmation of the underlying pricing in fixed income markets regarding the U.S. economy.
The 10 am release of the November University of Michigan consumer sentiment index is expected to be revised down to 74 from the initial 75 forecasted earlier in the month, which is still a two-year low.
Also at 10 am is the October index of leading economic indicators, expected to drop 0.3% from 0.3%, -0.8% and 0.7% in September, August and July respectively. So far, the mixed performance of the index over the past 6 months does not corroborate with the underlying deterioration in business activity, labor markets and financial markets.
USD/JPY slumps to two-year lows
The fact that today’s 150 point decline in USD/JPY to 29-month lows has gone on for 10 hours without any bouts of buying suggests the notable absence of any profit-taking, thereby reflecting the strength of the selling momentum as well as the fundamental backdrop to the declines. We are unlikely to see any significant disappointment in today’s consumer confidence report because it is the final release of the preliminary report, but the leading indicators index may come in as low as -0.5% due to deteriorating equities and rising jobless claims. The chart below shows that any corrective upmoves this week are likely to be limited at 110 and 100.40, while thin trading volumes in the next 36 hours will retest the 108 figure.
BoE recovers on CBI, risk appetite, capped at $2.07
Although the minutes of this month’s Bank of England rate decision showed there were only two dissenters demanding a 25-basis points rate cut (Deputy Governor John Gieve and usual dove David Blanchflower), we expect sterling’s fortunes to deteriorate against the U.S. dollar, despite escalating probabilities of a December Fed cut and subsequent cuts in 2008. The nine-member MPC panel at the Bank of England argued that a rate cut would further stoke up inflationary pressures considering rising oil and commodity prices. Last week BoE Governor Mervyn King said economic growth would weaken “sharply” but because the BoE is not facing the same extent of erosion in market confidence seen in the United States, it may be able to wait longer as long as inflation risks are on the upside. We expect cable to extend losses towards the $2.050 trend line support, followed by 2.0440. Dollar weakness and intermittent buying of equities may lift the pair towards $2.0630-40, but resistance is seen capped at 2.07. Key pressure stands at 2.0750.
Euro extends resilience
Euro extends strength across the board in the face of falling global equities as the catalysts ate seen largely originating from the United States rather than resulting from troubled institutions in Europe. The resilience in gold prices above the $800 is also helping to maintain EUR/USD above the $1.48. The onset of further weakness in this morning’s U.S. data will likely sustain bullishness into 1.4860, followed by 1.4890. EUR/USD shall also remain propped ahead of next month’s GCC nations meeting, where possible currency revaluations may be agreed upon. Renewed talk of a GCC revaluation emerged yesterday when UAE Economy minister said the government was serious about containing inflationary pressures, adding that a solution would be effective via either stability in the U.S. dollar or a change in the currency peg regime. We place the probability of a change in the UAE’s currency system from dollar peg to a basket of currencies as high as 60% at next month’s GCC meeting on currencies. Such a move is seen as a precursor to revaluation, which we expect to take part in Q2 2008. Support stands at 1.480, followed by 1.4770.
Ashraf Laidi
Chief FX Analyst
CMC Markets US
a.laidi@cmcmarkets.com
