The Bank of England (BoE) cuts interest rates by 25-basis points to 5.50%, in line with our forecasts. By choosing to act despite CPI standing at 2.1%, the central bank has emphasized deteriorating market conditions and the resulting credit tightening as well as slowing business and household spending. Broadening evidence of slowing housing prices and mortgage lending was also becoming increasingly hard to ignore by the central bank.
The rate cut brings an end to a tightening cycle that had 75-bps of rate hikes, the shortest tightening cycle since the BoE gained independence in 1997.
Rather than waiting until mid Q1 to cut rates, as was indicated by its inflation report, the central bank has clearly heeded the message of the markets.
We expect the central bank to resume easing into 2008, bringing base rates to 4.75% by year-end 2008.
We had mentioned our expectations for a rate cut was primarily a tactical decision based on cost/benefit, whereby the advantages of cutting rates versus the costs of overshooting rising inflation are greater than risking to wait until mid January, when the already accelerating momentum in financial market erosion may reach to emergency measures in January, prompting the BoE to make a 50-bps rate cut.
The central bank was already under scrutiny/criticism for not doing enough regarding the Northern Rock failure and for its slow reaction in providing liquidity in a faulty environment. With the last two weeks of the year risking to further fuel inter-bank rates and the economic data accelerating to the downside, the MPC may get the upper hand. The interest rate differential was also a key factor, relative to the United States and the euro zone. With the Fed expected to lower rates to at least 4.25%, leaving UK rates unchanged would have lifted the UK rate differential to a 2-1/2 year high of 1.50%, thus stoking further gains into the pound. In order to avoid the risk of acting too little too late in January, the BoE will have to cut rates by a quarter of a point. Our expectations of such outcome stand at 60%.
Cable dips to 2 1/2 month lows at $2.0179, with the bulk of the losses occurring before the BoE decision. While our month -end forecast-made 3 days ago projects Cable at $2.02, we expect the pair to extend losses in the interim towards $2.0170, followed by 2.0135. Key foundation stands at the 200-day MA of 2.01, while the 50- week average stands at $2.0. We suspect that further erosion in equities will become especially negative for the high yielding sterling, as the central bank has explicitly stated its concerns from financial markets. Upside capped at 2.04, followed by 2.06.
What to make of the S&P 500’s third failure?
On Monday, we mentioned the S&P 500’s visible failure to break above its 200-day moving average of 1485 over the prior two weeks. Despite Wednesday’s 1.5% rally, the S&P 500 closed at 1,485, barely above the 200-day MA of 1.484.19. This does not qualify as a convincing close above the key technical measure, thus raising questions about the sustainability of the recent bounce. The S&P requires a close of at least 5 points above its long-term average to shake off bearish sentiment. Fundamentally, the bear case for U.S. equities was validated by the fact that last week’s rally was largely a result of one-off factors, namely: Abu Dhabi Investment Authority’s $7.5 billion purchase of 5% in Citigroup and increased indications by the Federal Reserve officials that a rate cut may be needed at the December 11 meeting. Nonetheless, Wednesday’s rally emerged primarily due stronger than expected ADP report on U.S. private payrolls. But the question becomes the following: If equities had rallied on indications of Fed easing-preferably a 50-basis point cut, would a strong non-farm payrolls report justify the case of aggressive Fed easing--the very case behind the recent rallies?
Euro breaks below key trend line, eyes 1.4460
EUR/USD breaks below the four-month trend line support of 1.46, nearing further nearing our projected month-end forecast of $1.42. The forecast is predicated on:
expectations for emerging signs of cooling in the Euro zone;
increased erosion in capital markets reducing risk appetite and unwinding previous dollar longs;
end of year USD-repatriation by U.S. accounts, which should be especially dollar positive this time around considering the amount of dollar shorts prevailing in the prior 6 weeks;
our target for $720 gold by year-end, which is in line with a temporary bounce in the greenback.
Expecting a further decline in the EUR/USD at a time when the Fed is expected to cut rates does carry risks, especially as the ECB has a strong case to maintain its hawkish rhetoric (3.0% CPI).Yet, we expect market forces to prevail and steer FX repositioning in the favor of the U.S. currency until mid Q1.
EUR/USD eyes interim support at 1.4520, followed by the 50-day MA of 1.4460. Medium term support stands at 1.4350, which is the 38% retracement of the August low (1.3360) to the 1.4966 high. Rebound potential stands limited at 1.4580, followed by the trend line resistance of 1.46.
USD/JPY awaits jobless claims, S&P 500
While much attention is been given to the BoE decision and the 8:30 am ECB press conference, USD/JPY traders will focus on the 8:30 am release of U.S. jobless claims, and whether the series will show payback following last week’s unexpectedly strong 352,000. In the event that jobless claims remain above 335,000 to 340,000, they would suggest that the prior week’s release was a reflection of further cooling in U.S. labor markets rather than a statistical aberration. In such case, markets would be hesitant to expect a solid non-farm payrolls figure on Friday following the higher than expected ADP. The ADP report led us to revise our NFP forecasts to 90,000 from 70,000 to 75,000. Having said that, we do not rule out a negative NFP surprise following weak employment indices in the November ISM surveys.
U.S. equities will be the other element affecting yen pairs as it remains to be seen whether the broad indices will show two consecutive daily gains. Our aforementioned analyses of the S&P 500 cite renewed bearishness because of the failure to close well above the 200-day MA. Moody’s downgrades of insurer MBIA was among the latest array in the sub-prime flow of disconcerting news.
USD/JPY trades in a bullish wedge, testing trend line resistance at 111.05, a breach of which is expected to test 111.30, 38% retracement. Support stands at 110.50, followed by 110.20.
Ashraf Laidi
Chief FX Analyst
CMC Markets US
a.laidi@cmcmarkets.com
