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4 Scenarios for the Fed, but Only 2 Outcomes for the US Dollar

Monday, 10 December 2007 21:40:31 GMT  |  Kathy Lien, Chief Strategist

- Euro Rallies on Strong Data and Hawkish Comments

- Fastest PPI Growth in 16 Years Drives British Pound Higher

4 Scenarios for the Fed, but Only 2 Outcomes for the US Dollar

Traders across the markets are holding their breath for the last Federal Reserve interest decision of the year.  In our opinion, there are four possible scenarios for tomorrow’s rate decision but only two outcomes for the US dollar.  The most likely option is for the Fed to cut interest rates by 25bp and to issue a dovish statement reflecting concerns about growth.  Even though this would leave the door open for further easing in 2008, it may not be entirely dollar bearish because it disappoints the minority in the market looking for a larger 50bp rate cut.  The second scenario is also a 25bp cut, but one that is followed by a 50bp discount rate cut.  This would be more dollar bearish than the first scenario, but not enough to take the EURUSD back towards 1.50.  The third scenario is for a quarter point cut to be accompanied with neutral or hawkish comments, most likely related to inflation.  The chance of this is relatively low, but if it is the one that the Fed elects, it would be the most dollar bullish scenario.  The final possibility is a half point cut which would be the most bearish for the US dollar.  At the beginning of last week, there was a decent chance of that happening with probability of a 25 versus 50bp rate cut was close to fifty-fifty.  However now with less than twenty four hours to go before the interest rate decision, those probabilities have plunged to 72-28, with the higher percentage in favor of the more conservative move.  In our opinion, the Fed will most likely disappoint the market by under delivering.  Even though food prices remain high, oil prices have tapered off which means that the Fed may have slightly more flexibility in lowering interest rates.

Euro Rallies on Strong Data and Hawkish Comments

The Euro extended its rally for the third consecutive trading day following strong economic data and hawkish comments from ECB officials.  For those people who have been criticizing the Euro for hurting the Eurozone economy, their complaints continue to be refuted by economic evidence.  In the month of October, exports actually hit a record high in Germany and if you recall, that was the month that the Euro broke above 1.45 for the very first time.  Following the recent rise in manufacturing PMI, industrial production and factory orders, the boost in exports is not too much of a surprise.   Instead, what is more surprising is the soft growth of imports.  Domestic demand is beginning to wane and that could be a cause for concern.  Tomorrow we are expecting the German ZEW survey, which is expect to drop to a new 15 year low but analysts have been notoriously pessimistic and as a result, have incorrectly forecasted Eurozone growth for the past few months.  For this reason, we actually believe that the ZEW survey could surprise to the upside as analysts finally recognize the stability of recent Eurozone data.  Furthermore, the Euro is also benefitting from ECB officials repeating the hawkish comments made by Central Bank President Trichet last week.  Both Liikanen and Stark warned of upside inflation risks next year, which tells us that this week’s consumer price data could be particularly firm.

(Get the latest on the ECB meeting at the end of the EUR Currency Room)

Fastest PPI Growth in 16 Years Drives British Pound Higher

Last week, the Bank of England cut interest rates for the first time in 2 years, which should have been bearish for the British pound, but wasn’t.  At that time, the market did not think about what the rate cut meant, but instead about whether it would be the one and only rate cut from the BoE this cycle.  This suspicion was first raised by the statement released by the central bank, which was not entirely dovish.  Today, that suspicion was confirmed by producer prices, which grew by the fastest pace since 1991.  Food and energy prices have been on the rise and we are finally seeing that upside pressure being passed on to consumers.  This pace of producer price growth will make it difficult for the Bank of England to cut interest rates again when they meet in January, unless the UK economy slows materially.  Tomorrow we are expecting the UK trade balance.  Firm industrial production should help reduce the trade deficit. 

(Get the latest on the BoE meeting at the end of the GBP Currency Room)

Australia, New Zealand Dollars Recover, But Caddy Remains Steady

The Australian and New Zealand dollars are stronger today thanks to a $13 rise in gold prices and a rebound in carry trades.  There was no major data released from either country and aside from the NAB’s measure of business conditions in Australia, no major economic data is expected tonight either.  Instead, the next move in these currencies will be largely contingent upon the market’s reaction to the Federal Reserve’s interest rate decision.  Should the Dow rally on the rate announcement, we could a similar move in the high yielders.  The Canadian dollar on the other hand has barely budged.  Housing starts were stronger expected but that seemed to be offset by a drop in oil prices.  This is a quiet week for the Canadian dollar and we expect more consolidation or profit taking around current levels. 

(Discuss the Canadian Dollar in the USDCAD Thread on the DailyFX Forum)

Carry Trades Break Higher As Dow Climbs 100 Points

On Friday, the Dow stalled, leading many people to wonder whether we have seen a top in US equities.  Although we could be nearing one as resistance looms at 13,800, today’s 100 point rally in the Dow has helped to take the Japanese Yen crosses higher.  Despite stronger than expected money supply and machine orders, the economy continues to be held back by weak sentiment.   Last night, the Eco Watchers survey for the month of November dropped from 41.5 to 38.8, a four year low.  Unless the government finds a way to revive consumer spending and boost consumer sentiment, they will have a tough time supporting an interest rate hike.  Since there is no overnight solution, expect the Yen crosses to continue to dance to the tune of the Dow in the interim. 

 

 

By Kathy Lien, Chief Strategist of DailyFX.com

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