The U.S. dollar extends its losses and risk aversion accelerates despite the Fed’s latest $50 billion liquidity boost in repos. The 0.1% decline in the consumer price index (CPI) confirms last week’s release of the unexpected 0.9% decline in August producer price index (PPI). The shocking decline in August retail sales and yesterday’s unexpected 1.1% drop in August industrial production (vs. expectations of +0.2%) combined with the notion of peaking inflation and faster breaking macroeconomic fundamentals supports our calls for increased focus on shoring up growth vs. tackling inflation. The downside risks are not just about credit and liquidity.
We expect a 50-basis point (bp) rate cut in the Fed funds rate to 1.50% along with a similar 50-bp easing in the discount rate to 1.75%. Despite the $70 billion in overnight repurchase agreements pumped up by the Fed on Sunday night and the just announced $50 billion announced minutes ago, the U.S. central bank is facing a state of crisis in the financial markets from a perspective of solvency, liquidity and confidence. This morning’s $50 billion liquidity boost drove down the effective Fed funds rate down to the 2.00% target from 3.75%. For these reasons, the Fed has no choice but to resort to interest rates to maintain stability in the financial system.
Skeptics who indicate that U.S. interest rates are already too low for the current high inflationary environment must remember that in 2002, U.S. interest rates fell to 1.00% at a time when the housing market was firm, credit markets were liquid and bank solvency was intact.
The depth of uncertainty and market fear is highlighted by the fact that neither an announcement by the NY Federal Reserve injecting an additional $50 billion in overnight repos, nor reports of Goldman Sachs buying Wells Fargo have proved sufficient in allaying market fear and the sell-off in equity futures. The VIX broke closed above the 30 level for the first time since the week of the Bear Stearns rescue in mid March.
FOMC options & forex implications
A 50-bp rate cut in the Fed funds rate would be the most generous result for risk appetite as far as realistic outcomes are concerned, in which case we could see a rapid and short-lived decline in the yen across the board, a broad dollar decline with the exception of against the yen. The resulting yen decline will only go as far as the duration of the rally in stocks, which will also be partly dependent on whether the Fed would cut the discount rate.
Alternatively, the Fed could hold the Fed funds rate steady and cut the discount rate by 50-bps from 2.25%, to below the Fed Funds rate at 1.75%. Such an outcome could also be effective in stemming risk aversion, but it is vital to stress that a great deal of this depends on finding capital for AIG.
Such measures will ultimately be seen more of an assault in the dollar’s interest rate foundation than shoring up sentiment in the U.S. currency.
USD/JPY is expected to find the 103 target and accompanied by broad declines in the yen crosses. EUR/USD is apt to regain $1.4350-55. GBP/USD remains widely boosted by weak USD, thereby making all upward moves temporary. Resistance stands at $1.7960 and $1.8000. Aside from USD/JPY, USD/CHF is the other main pair dragging on the USD, eyeing interim support at 1.1020 followed by 1.0960. USD/CAD is the main USD pair working in favor of the U.S. currency amid the substantial decline in oil below $99. Upside seen capped at 1.0770.
Ashraf Laidi
Chief FX Strategist
CMC Markets US
a.laidi@cmcmarkets.com
