Risk appetite is gradually reverting to the market as the dollar loses some of its earlier post Federal Open Market Committee (FOMC) gains and higher yielding currencies regain composure. The yen is also paring back part of its gains as markets reconsider the FOMC statement. Reports that the Federal Reserve may be resorting to special liquidity injecting measures - other than cutting interest rates - reflect a sense of urgency by the central bank that may ease markets’ concerns.
One more comment about the Fed decision; we believe the FOMC statement left the door wide open for further future easing despite the smaller reduction in both the fed funds and discount rates. The sharp drop in equities was a natural and obligatory unwinding of previous weeks’ gains that were built on hopes (not expectations) of more aggressive Fed easing and excessive optimism from SWFs’ injections. The losses in equities were also a result of the Fed’s removal of the phrase spelling out the balance of risks. Although the statement did not indicate whether the upside risks to inflation was roughly equal to the downside risks to growth, the indication of: ”intensification of the housing correction … softening in business and consumer spending... strains in financial markets” should be a signal of forthcoming easing in the event of further deterioration. The statement may have appeared hawkish relative to individual expectations, but in fact, the explicit expression of downside risks suggests proclivity for further policy action ahead. As for the continuous spelling out of inflation risks, we view these as an obligatory addition by any central bank under the current inflation environment, but that will not prevent the Fed from further easing as risks of a gross domestic product (GDP) growth contraction in Q4 coupled with renewed write downs will set the tone. We expect 75-bps of easing in the next three FOMC meetings (January, March, April), bringing down the fed funds rate to 3.75%.
This morning’s release of the U.S. trade deficit is expected to show a rebound to $57.5 billion in October from $56.5 billion in September. We expect a bigger rise in the range of $58 billion due to the sharp increase in oil prices prevailing in October. An unexpected decline in the deficit will lend considerable boost to the dollar on optimism that the currency’s depreciation is continuing to spill over to the overall trade imbalance.
Euro remains in downtrend
Despite the euro’s rebound from its $1.4638 lows to $1.4724, we continue to deem the pair “not out of the woods yet.” Euro zone industrial production rose 0.4% m/m, 3.8% y/y in October, from a sharp downward revision in the September figures to -0.8% m/m (from-0.7%) and -3.3% (from +3.5%).
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. Support starts at 1.4640, followed by 1.46 and 1.4580.
USD/JPY rebound seen limited
The extent of any rebound in USD/JPY depends on the scope of dollar gains resulting from a possible surprise in the trade report and the prolonged gains in equity futures translating into real gains in the cash market. While Tuesday’s equity market sell-off may have appeared an overreaction, it does not preclude the notion that the overall trend remains predominantly down, interrupted by dosages of optimism from reports of SWF’s stabilizing shaky sentiment, and inconclusive plans to freeze interest rates on sub-prime mortgages. Thus, we may well see a USD/JPY positive opening in equities that could be followed by subsequent pullback in the final stages of trading, in which case will send USD/JPY lower.
We expect USD/JPY gains to be capped at 111.30, followed by 111.50, while renewed losses seen extending towards 110.90 and 110.50.
Sterling’s rebound seen capped at $2.0480
Sterling recovers from its $2.0320 lows after UK claimant count unemployment fell by 11,000 last month, overshooting expectations of a 5,000 decline. The slight softening in average earnings growth to 4.1% from 4% may not be enough to convince the Bank of England of a definitive retreat in pay as long as the figure remains well above the desired 3.5% rate, but the deteriorating conditions in the financial sector will dampen bonuses and base compensation.
Despite today’s gains, sterling rests on a shaky foundation, which was clearly seen in the currency’s declines prior to the FOMC announcement. Cable stands capped at $2.0460, followed by 2.0490, while support is underpinned at 2.0420, followed by $2.0370.
Ashraf Laidi
Chief FX Analyst
CMC Markets US
a.laidi@cmcmarkets.com
