Will the Fed be Proactive (50bp) or Reactive (25bp) on September 18th?
The biggest debate in the currency markets at the moment surrounds what the Federal Reserve will do on September 18th. We expect the upcoming interest rate decision to create a great volatility in the financial markets because with less than a week to go, economists and traders have yet to reach a consensus on how much the Federal Reserve will lower interest rates, if at all. According to the 117 economists surveyed by Bloomberg, 69 percent expect a quarter point cut, but according to a DailyFX Poll of 255 voters, only 48 percent expect the Fed to move.
It has become painfully obvious that Federal Reserve Chairman Ben Bernanke has encountered the "first year curse," where new Fed Chairman are faced with a major financial crisis shortly after taking office. The recent rally in the global equity markets and the sell-off in the US dollar indicate that some type of easing is expected, but the question is still, "do current conditions and future outlooks warrant a 25 or 50 basis point rate cut?" In our opinion, this is really a question of whether the Fed chooses to deal with the problems in the US economy proactive or reactively. A 25bp cut would be putting be a band aid on the subprime and credit crisis in hopes that the problem does not exacerbate while a 50bp cut would represent an aggressive move by the Federal Reserve to tackle the problem before it worsens.
What Kind of Economy Is The Fed Grappling With?
While the markets have been speculating for weeks that the Federal Reserve will move to lower interest rates on September 18th, the release of dismal labor market data on Friday, September 7th essentially cemented the prospects of a rate cut. US non-farm payrolls declined for the first time in four years during the month of August. The 4k drop was particularly dour against estimates of a fairly strong reading of 100k. Surprisingly, the unemployment rate remained unchanged at 4.6 percent, but this was largely a function of a drop in the labor force participation rate to its lowest since 1988. Countrywide Financial Corp. added to the gloomy sentiment by announcing later on the same day that the firm would cut 10,000 to 12,000 jobs – about 20 percent of the company's entire workforce. With the housing recession only worsening and likely to seep into other areas of the economy, the situation for domestic laborers is likely to grow increasingly worse through the medium term.
The collapse of the subprime mortgage market and subsequent impact on the labor market could have other negative effects as well. First, household sentiment has already started to take a hit as the Conference Board's consumer confidence index fell during the month of August to a one year low of 105.0. A breakdown of the index shows that Americans are far less optimistic, as the number of people indicating that they expect business conditions to worsen, fewer jobs to be available, and income to decrease within the next six months all picked up. This gloomy sentiment signals that consumption growth could suffer, especially as volatile financial markets and high gas prices are unlikely to abate in the near-term. Thus far, US retailers have performed fairly well, as the International Council of Shopping Centers (ICSC) recently reported that August chain-store sales saw 2.9 percent increase from last year. However, it appears that most of the improvements came as a result of massive discounting, as chains like Wal-Mart and Macy's have slashed prices in order to draw customers, which has the potential to slim-down profit margins. Retailers won't be able to use these tactics forever, and a slowdown in consumption is likely to show through eventually. Even retailing executives are leery about the outlook. Last week Myron E. Ullman, chief executive of JC Penney said, said in reference to shoppers' anxiety about the economy, "It will be tougher than it is now. I do not see anything on the horizon that will turn this around." With the US consumer responsible for almost 70 percent of GDP, the risks for a sharp slowdown in economic expansion in Q3 and Q4 rise dramatically.
It's Not A Matter Of If They Will Cut, But By How Much…
Given the feeble condition of the US economy, and the even more fragile outlooks, there is little doubt the Federal Reserve will cut rates in September. According to the Fed Fund futures curve there is a greater chance of 75bp of easing than no cut at all. The consequences of unchanged rates would be severe. The entire yield curve would be repriced and the stock market would collapse. Therefore the more important question is: will the Fed deliver a 25 basis point cut or a 50 basis point cut?
25 Basis Points
A 25 basis point cut following the Federal Reserve's September 18th meeting is very much priced into Fed fund futures and has been ever since August 9th, when the liquidity crunch initially hit bond and equity markets. In fact, just a day prior, the markets were pricing in only a 20 percent probability of a September cut and 100 percent chance of only one 25 basis point reduction by the end of the year. Of the 117 economists surveyed by Bloomberg 81 indicated that they thought the central bank would reduce rates to 5.00 percent during the third quarter. This slower approach to loosening monetary conditions may be preferred by the Federal Reserve, as Bernanke will likely want to allow time to gauge the impact of their previous policy actions. Furthermore, the US dollar, carry trades, and equity markets may be more even-keeled in coming months as a less extreme policy move in the near-term would create the potential for additional policy action in the long-term. Nevertheless, traders should count on a spike in volatility on the announcement of any policy decision and sustained weakness in the US dollar as long as the Fed is expected to cut rates again. Keep an eye on the FOMC statement
50 Basis Points
As we mentioned above, a 25 basis point interest-rate cut is already priced in for September, but what about a more dramatic cut? At the time of writing, Fed Fund futures show a greater than 50 percent chance of a half-point cut to 4.75 percent, however, only 24 out of 117 economists polled by Bloomberg agree with this outlook. However, given the sharp decline in last Friday's non-farm payrolls report, this outcome has become more realistic and of the equity markets start to get pummeled once again, the probabilities of such a move will only increase. Over the next few months, a 50 basis point cut may prove to be the most bullish for equity markets, who will breathe a sigh of relief, but bearish for the US dollar as interest rate differentials would be quickly out of favor for the currency.
What About the US Dollar and Carry Trades?
One of the most surprising things we initially saw in the forex markets when global stocks were first sent reeling in early August was the fact that the US Dollar strengthened against currencies like the Euro and British Pound, while carry trades unraveled at a frightening pace. However, we saw this dynamic shift on September 5th, when US pending home sales were released at a horrid -12.2 percent. The news was so bad that it cemented the prospect of lower US interest rates in the minds of forex traders, sending the US dollar plummeting against the majors – including the Japanese yen – even as the Dow tumbled 150 points. The shift also signaled that the greenback was no longer being utilized as a safe-haven asset by international investors. Since then, the financial markets have stabilized somewhat, with carry trades and equity markets moving in tandem, while dour US economic data leads the US dollar to weaken.
Going forward, the potential for policy action by the Federal Reserve will make the US dollar less attractive amidst lower interest rates and slower growth prospects. In fact, the US dollar doesn't stand much of a chance of strengthening significantly in the near-term unless the central bank does the unexpected: leaves rates steady. This decision would quickly bring back the scenario where the US dollar rallied as a safe-haven asset while US equity markets crumbled.
Meanwhile, the status of the once-lucrative carry trade will remain contingent upon the status of equity markets, which has served as an excellent barometer of the risk-seeking nature of forex traders. As a result, if policy action (or lack of it) by the Federal Reserve fails to leave Wall Street satisfied, the profitability of carry trades could deteriorate further. On the other hand, rate cuts by the central bank, especially successive ones throughout the next few months, will send pairs like GBPJPY and EURJPY rocketing higher.By DailyFx
US: FOMC likely to cut by 25bp in September
To gauge interest rate movements around the FOMC meeting on September 18, it might be useful to look back to the situation in 1998 where the FOMC started cutting rates at itsSeptember meeting from a peak of 5.50%. The following quote from the September 1998 Minutes illustratesthe similarities between the situation back then and now:
Although the domestic economy is weaker than in 1998, the situation currently facing the FOMC has many parallels to the situation back then. In particular, the FOMC also today faces global financial market turmoil and high uncertainty about the impact on economic growth. Hence, we think the interest rate movements around the Fed cuts in late 1998 represent a useful benchmark for movements in USD interest rates in the coming months.
Charts A and B on the front page display the Federal Funds target rate and 2Y and 10Y USD bond yields, respectively, around the Fed cuts in 1998. Interest rates started falling well ahead of Fed's rate cuts. They continued declining after Fed's first rate cut before stabilising at a higher level around the time of the third rate cut. In other words, bond yields were 'over-shooting'.
Another instance of 'over-shooting' occurred in 1995-96 when the Fed also cut the Federal funds target three times before going on hold. Charts C and D display how 2Y and 10Y bond yields evolved duringthis period. Bond yields trended down between the first and third rate cut, before shooting up in the months fol-lowing the third rate cut in January.
In the cases referred to above, when the Fed starts cutting interest rates, markets often anticipate it as the beginning of a longer sequence of rate cuts. This behaviour is merely a reflection of the extrapolative nature of financial markets. However, in cases with only a short sequence of rate cuts, this naturally leads to over-shooting. As market expectations align with actual Fed policy, this overshooting is reversed.
'Overshooting' to reappear
Based on the similarities between the situation now and in 1998, we think the 'overshooting' scenario could be repeated over the coming months. Ifour Fed call of two 25bp rate cuts at the September and the October meetings carries through, bond yields would probably rise as markets currently price in a more dovish Fed path. Consistent with this, our recent Interest Rate Forecast from September 3 implied lower USD rates at the 1M horizon and higher USD rates at the 3M horizon.
The risk to our 'overshooting' scenario for USD rates is that stronger evidence of an impact from the finan-cial crisis to the broader economy starts to emerge. For example, if last Friday's weak Non-Farm Payrollsfigure turns out not to be a temporary dip, then bond yields might well extendthe recent downward trend. However, we expect the US labour market to recover from this very weak reading, see 'US: Weak job mar-ket in August' and the 'overshooting' scenario remains our central expectation.
The first two columns in the table below shows average spreads between 10Y/2Y bond yields and the Fed-eral Funds target rate in a five-day window leading up to the first Fed cuts in 1995 and 1998. The last col-umn displays current market levels for these spreads. Using these time windows prior to the first Fed cuts in 1995 and 1998 as benchmarks, it appears that current spreads appear low. In other words, bond yields appear low relative to the 1995 and 1998 benchmarks. The bottom line is that bond yields might be over-shooting at present.
Note: The first two columns of the table report average spreads in percentage points. The last columnreports current spreads using the following bond yields. 10Y: 4.3372Y: 3.878
by Danske Bank
U.S Market Update 12 Sept 07
- There are no major economic numbers scheduled for release in the US today, however MBA mortgage applications for the week ending September 7 will be released at 7:00 ET. There are no estimates for the mortgage applications number; the prior reading was 1.3%.
- There is no new supply scheduled in the US today. As expected, the Treasury announced yesterday that they will be selling $8B in 10-year notes. The results from the 10-year note auction are due out mid-session on Thursday.
- There are no central bank speakers scheduled in the US today.
- In European economic news overnight, Euro-Zone industrial production for the month of July was stronger than expected, with small upward revisions to June’s readings. Industrial production was 0.6% m/m and 3.7% y/y, above estimates of 0.2% and 3.1% respectively. In the UK overnight, the claimant count rate for the month of August was in line with consensus expectations at 2.6%, while July’s reading was revised up to 2.7% from 2.6%. The jobless claims change was slightly better than expected at –4.2K. Average earnings including bonus rose by more than expected to 3.5% in July from an upwardly revised 3.4% in June, while average earnings excluding bonus were in line with estimates at 3.5%. The ILO unemployment rate for the month of July was also in line with consensus estimates at 5.4%. The Bank of England’s King said overnight that the money-market rescue risks a future financial crisis, adding that interest rates could be adjusted quickly when necessary.
- In Asian economic news overnight, Japanese Prime Minister Abe announced his resignation. Chinese retail sales for the month of august rose by more than expected to 17.1% for the highest reading since May 2004. Chinese M2 money supply rose declined by more than expected to 18.1% in August from 18.5% in July. Japanese consumer confidence for the month of August unexpectedly declined to 44.1 from 44.6 I July, while household consumer confidence declined in line with consensus expectations to 44.0 from 44.4 in June. The seasonally adjusted South Korean unemployment rate declined to 3.2% from 3.4% in July.
by Trade The News Staff
Dollar Erases Losses Against Euro After Falling to Record Low
Sept. 12 -- The dollar erased losses against the euro after earlier falling to a record low, and pared its decline versus the yen.
The dollar declined for a sixth day against the common European currency, the longest losing streak since April, as investors bet the U.S.'s interest-rate advantage over Europe will narrow amid the housing market slump.
The dollar traded at $1.3844 per euro by 9:05 a.m. in London, little changed on the day, after earlier declining to an all-time low of $1.3878. That compares with the previous low of $1.3852 reached on July 24.
The U.S. currency also slipped to 114.07 yen from 114.27 yesterday, on speculation Japanese investors will trim riskier overseas bond holdings after Prime Minister Shinzo Abe said he will resign.
By Lukanyo Mnyanda (Bloomberg)
U.K. Pound Erases Gains Versus Dollar, Declines Against Euro
Sept. 12 -- The pound erased earlier advances against the dollar and fell versus the euro on speculation interest rates in the U.K. have peaked.
The pound traded at $2.0319 by 9:15 a.m. in London after rising to $2.0360 earlier, and compared with $2.0333 yesterday. Against the euro, the pound fell to 68.14 pence from 68.06 in the previous session.
By Anchalee Worrachate (Bloomberg)
Australia Dollar Rises on Increased Confidence in Global Growth
Sept. 12 -- The Australian dollar rose to the highest in almost a month as signs global economic growth will be sustained gave investors confidence to buy the country's higher-yielding assets.
The currency gained for a second day after U.S. stocks rallied the most this month on evidence consumers are weathering an economic slowdown stemming from losses in subprime mortgages. Australia's dollar was also boosted as metals prices increased on demand from China. Exports of raw materials add about 14 percent to the country's economic growth.
``The Australian dollar has a bit of positive momentum,'' said Greg Gibbs, a currency strategist at ABN Amro Holding NV in Sydney. ``The view at the moment is that global growth will hold together with the strong equity market and strong metals.''
The Australian dollar advanced 0.7 percent to 83.28 U.S. cents at 11:15 a.m. in Sydney from 82.68 cents late in Asia yesterday, and may reach 84 cents today, Gibbs said.
The local dollar climbed against 15 of its 16 most-active currencies from yesterday, rising the most versus the yen to buy 95.11 from 93.86 yen. Only New Zealand's dollar, another so- called commodity currency, gained by more.
Gibbs said Australia's dollar had also been supported by a weaker U.S. dollar, which has fallen against 12 of its 16 most traded counterparts this month as investors have raised bets the Federal Reserve will cut interest rates.
Australia's dollar benefited after the Standard & Poor's 500 Index added 1.4 percent in New York yesterday, as General Motors Corp. said demand is strong enough to charge more for cars. The region's stocks followed, with the Morgan Stanley Capital International Asia-Pacific Index of shares advancing 0.6 percent. Australian shares gained for a second day.
The London Metal Exchange Index, which tracks futures contracts of six metals including copper and aluminum, strengthened 3.2 percent yesterday, the biggest jump since April. Australia's dollar has increased more than 50 percent over the past five years, as the LME index more than tripled.
The Reserve Bank of Australia last week kept its interest- rate at an 11-year high of 6.5 percent. That compares with the 5.25 percent U.S. cost of borrowing and Japan's benchmark rate of 0.5 percent, which is the lowest in the industrialized world.
Australia's government two-year benchmark bonds yield 2.32 percentage points more than similar-maturity Treasuries, close to the almost three-year high of 2.43 percentage points spread reached Sept. 7. The premium over Japan's two-year notes is 5.46 percentage points, after reaching an almost 5-month high 5.51 percentage points late last week.
The yield on the Australian two-year bond rose 2 basis points to 6.26 percent. The price of the 7.5 percent bond maturing in September 2009 fell 0.047, or A$0.47 per A$1,000 face amount, to 102.285. Bond yields move inversely to price and a basis point equals 0.01 percentage point.
By David McIntyre (Bloomberg)
Bank of America Raises Yen Forecast to 117 a Dollar From 120
Sept. 12 -- Bank of America N.A. raised its 2007 forecast for the yen to 117 against the dollar as Japanese individuals invest fewer savings overseas.
The yen has rebounded from a 4 1/2-year low in June to become the best performer among the 16 most-active currencies in the past month as falling stocks discouraged Japanese housewives, pensioners and businessmen from taking out loans to buy higher- yielding assets. The Bank of Japan's 0.5 percent benchmark borrowing cost compares with 6.50 percent in Australia and 8.25 percent in New Zealand.
``Japanese investors' tolerance for risk is decreasing,'' Tomoko Fujii, head of economics and strategy for Japan at Bank of America in Tokyo, said in an interview today. ``Their courage for investing overseas isn't as strong.''
The yen traded at 114.09 against the dollar at 11:13 a.m. in Tokyo compared with 114.27 in late New York yesterday and 124.13 on June 22. Fujii previously forecast the currency to fall to 120 against the dollar by year-end.
The strategist at the second-largest U.S. bank joins Barclays Capital, Bank of Tokyo-Mitsubishi UFJ, Mizuho Corporate Bank Ltd. and Daiwa Securities Group in raising forecasts for the yen in the past three weeks. Bank of America's estimate compares with a year-end median forecast of 116 yen in a Bloomberg News survey of 44 strategists and economists.
Japanese investors sold more foreign bonds than they bought for a third month in August, with net sales of 690.4 billion yen ($6.05 billion), data from the Ministry of Finance showed today. The yen rose 2.4 percent versus the dollar last month.
`Hard to Imagine'
Japan's currency has jumped 7.8 percent since June 22, when Bear Stearns Cos., the fifth-biggest U.S. securities firm by market value, said it would bail out a hedge fund that lost money on securities related to subprime mortgages.
Borrowing of yen to purchase higher-yielding currencies by mom and pop investors has contributed to the more than 5 percent decline in the past year versus New Zealand's and Australia's dollars, favorite targets for so-called carry trades. Japanese investors have 1,536 trillion yen in financial assets, according to figures from the central bank.
In a carry trade, investors get funds in a country with low borrowing costs and invest in one with higher interest rates, earning the spread between the borrowing and lending rate. The risk is that currency moves erase those profits.
Yen short positions against seven major currencies such as the dollar and euro fell by 54 percent to 192,543 contracts on Aug. 17 from 420,758 on Aug. 9, according to Bloomberg calculations based on data from Tokyo Financial Exchange Inc., Japan's largest financial futures market.
A short position is a wager on a currency's decline. The contracts are denominated in 10,000 units of the foreign currency. The Bank of Japan estimated the Tokyo futures exchange has a market share of 5.8 percent of margin trades as of December 2006.
``It's hard to imagine risk appetite will return to the high levels of pre-market turmoil in August,'' Fujii said.
By Kosuke Goto (Bloomberg)