Dollar is modestly higher ahead of this afternoon’s FOMC decision, increasingly expected to produce a 25-basis point rate cut in the Fed funds rate to 4.25% and a 50-bp rate cut in the discount rate to 4.50%. The anticipated easing in the discount rate will reduce the margin over the Fed funds rate to 25-bps from 50-bps, thus encouraging banks to seek funding from the discount window. The smaller easing option of 25-bps in the Fed funds rate, rather than 50-bps, is expected to help the dollar from a yield- and risk-appetite perspective. A 4.25% Fed funds rate would be more beneficial to the U.S. currency than 4.00% interest rate, while a less generous easing will likely disappoint a shaky stock market, and curtail risk appetite. Renewed selling in equities will weigh on higher yielding currencies, particularly the Aussie and sterling, whose central banks are less inclined to pursue a hawkish stance. A resulting rally in the U.S. dollar is also likely to be fuelled by a pullback in gold to as low as $780 per ounce.
FOMC statement may make difference
While a 25-bp rate cut is expected to be generally positive for the dollar, the exception to this forecast may emerge in the event that the central bank issues a more dovish statement than in the October meeting as it shifts the balance of risks towards further slowing in the economy from the balanced view between inflation and economic slowdown issued in October. Such an outcome is highly probable, especially after the Federal Reserve downgraded its 2008 and 2009 forecasts for GDP growth and inflation.
A 50-bp rate cut would be a positive surprise for risk appetite and is likely to boost U.S. equities at the expense of the dollar, which would sustain a bigger erosion in its yield foundation. In the unlikely event that the Fed funds rate is held unchanged, we expect a sharp sell-off in U.S. equities (2% to 3%) and considerable gains in the dollar across the board accompanied by a $25 to $30 per ounce decline in gold.
Euro drops below $1.47 as ZEW hits 15-year low
EUR/USD dropped below the $1.47 after Germany’s ZEW index of investor sentiment fell to -37.2 in December from -32.5 in November, undershooting consensus forecasts of -35. The current situation index worsened to 63.5 from 70.0 versus expectations of 66.0. The ZEW said consumption will remain mostly stable over the next six months, but does not see a recovery as “Domestic and global uncertainties are significantly slowing down growth dynamics.”
Failing to breach above the 1.4750 yesterday, EUR/USD remains well inside its two-week trend line, suggesting that further declines are ahead, possibly to start after today’s FOMC decision. Our bearish stance on the euro rests on fundamental and technical grounds. Unwinding of dollar shorts towards year-end and increasing signs of a cooling in the Euro zone will keep fresh euro longs at bay, while the emerging head-and-shoulder formation in EUR/USD remains intact now that the pair failed to break above the 1.4750 right shoulder. The level also marks the 50% retracement of the decline from the 1.4966 high to the 1.4524 low. Subsequent resistance stands at 1.4770. With the 1.4660 support being broken, we expect intermediate support to stand at 1.4620, followed by 1.4580.
USD/JPY eyes 112.75
Escalating risks of slowing Japanese growth are prompting further broad yen selling, which has especially been driven by the recent surge in risk appetite in global equities. We could see further yen losses against the dollar from a quarter of a point Fed move.
Yen crosses may also follow lower in the event of a positive reaction in U.S. stocks. Technically however, EUR/JPY shows increased signs of toppishness, raising the risk of a turnaround towards 163.
USD/JPY breaks above a key two-month trend line resistance at 111.75 and may be slated for further gains towards the 112.50. With the 25-bp Fed rate cut expected to be more dollar positive than a 50-bp cut, the pair is expected to ride those gains. Nonetheless, an especially dovish statement from the Fed may temper these dollar gains and impose resistance just above 113, the 50-day moving average. Support creeps higher to 111.30, followed by 110.80.
Sterling propped up by trade figures, gains limited at $2.0560
Sterling shows a rare positive decoupling from the euro, pushing into the $2.05 figure after UK’s trade deficit in goods narrowed in October to GBP 7.1 billion, better than expectations for GBP 7.3 billion. The decline was partly due to a revision in the September figure to GBP 8.0 billion from GBP 7.8 billion. The report may suggests the UK has shown little signs of being affected by the global slowdown, but it is the domestic economy and ensuing slowdown in housing that is most likely to dampen growth and prompt the Bank of England (BoE) to cut rates by another 50-bps into 2008.
The trade figures buoyed sterling across the board and extended cable past the $2.05 trend line resistance towards $2.0520. We raise our projected resistance to $2.0560, which marks the 38% retracement and the 50-day MA. We continue to expect $2.01 by end of month, while interim support climbs at $2.0450.
Aussie trendline remains down
Aussie pulls off its highs to 88.27 after the November NAB business confidence index eased to 6 last month from 9 prior, while the current conditions index fell to 15 from 20. The NAB stated, “The current problems in financial markets via their impact on increasing the cost of bank funding and slowing global growth could well mean that the RBA has already reached the peak of its current rate tightening phase.” Separately, RBA governor said that higher borrowing costs might reduce inflation, even without a rate hike. The statement dragged the Aussie off its 0.8894 high to 0.8827.
We may see renewed retreat towards the 0.8840s and testing 0.8800, especially if U.S. stocks lose more than 1.5%. Similar to the downtrend in EUR/USD, AUD/USD, remains in a trend line capped at 0.89.
USD/CAD eyes 1.0180
We expect further losses in the loonie, pushing USD/CAD higher past the 1.0150 and onto the 1.0180 trend line. Further USD strength from a 25-bp Fed cut may further elevate USD/CAD to 1.02. In the event of an intensified pullback in equities, we expect the pair to breach 1.02 towards 1.0240. Only a 50-bp rate cut from the Fed and/or an especially dovish statement may weigh on the pair, calling up the 1.0070 support.
Ashraf Laidi
Chief FX Analyst
CMC Markets US
