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Could the Fed Really Cut by 50bp?

Tuesday, 04 December 2007 21:27:58 GMT  |  Kathy Lien, Chief Strategist

- Canada Cuts Rates by 25bp, Reserve Bank of Australia and New Zealand Up Next

- Euro Rises After Stronger PPI Numbers

Could the Fed Really Cut by 50bp?

The lack of US economic data today led to directionless trading in the dollar which strengthened against the commodity currencies but weakened against the Japanese Yen and Euro.  Fed fund futures are now pricing in a 50 percent chance of a half point rate cut, which means that next week’s interest rate decision could really be a coin toss.  The division of expectations is also reflected in the range bound price action in the major currency pairs because no one knows for sure how much the Fed will cut.  Even though the futures market is pricing in a 50 percent chance of a half point rate reduction, the US dollar is not.  The shift in expectations compared to two weeks ago is dramatic but we have not seen an equally impressive move in the currency market.  If economic data continues to weaken, more currency and futures traders may be convinced that a larger rate cut is possible.  The first test will be this Friday’s non-farm payrolls report.  Tomorrow we get the most important leading indicators for non-farm payrolls, which are the Challenger Layoffs report, the ADP employment survey and the employment component of service sector ISM.   So far, jobless claims and the employment component of manufacturing ISM points to a weak release which is why the current forecast is for only a 70k rise.  If we have any reason to believe that the number will be even weaker, fundamentals could take the EURUSD up to our 1.50 price target.  Meanwhile the Gulf Cooperation Council meeting ended today with Mideast nations leaving the door open for individual revaluations.  There was no consensus reached at the meeting as the region’s 2 largest economies (Saudi Arabia and the United Arab Emirates) debated their options heatedly. Revaluations by the oil rich nations would have more symbolic than economic consequences for the US dollar.

 Canada Cuts Rates by 25bp, Reserve Bank of Australia and New Zealand up next. 

The surprise interest rate cut from the Bank of Canada wasn’t much of a surprise if you read my Daily Fundamentals from yesterday. With CPI dropping below 2 percent for the first time since June 2006, the central bank had plenty of room to respond to softening global growth. Although the BoC believes that growth is broadly in line with their expectations thanks to strength in domestic demand, the Canadian dollar has increased competitive pressures for exporters. They now expect inflation to be lower than projected over the next few months which left the door open for another interest rate cut.  Interest rate decisions from Australia and New Zealand are up next.  We do not expect either central bank to surprise the markets by changing interest rates. The RBA decision should be a nonevent since they do not release a statement when rates are unaltered.  GDP will probably be the more market moving event.  The RBNZ will be following up with their rate decision Wednesday afternoon.  Unlike the RBA, New Zealand does make comments regardless of what they do with interest rates which could make tomorrow an interesting trading day for the Kiwi.  The odds are skewed towards hawkish comments. 

Euro Rises After Stronger PPI Numbers

Like consumer prices, producer prices surged in the month of October to the fastest pace this year.  The 3.3 percent annualized growth rate is well above the ECB’s 2 percent target and reflects the inflationary picture that the ECB faces.  Thursday’s rate decision will be a difficult one for the ECB as they have to weigh slowing growth with faster inflation.  Comments from ECB members today were as conflicting as ever with ECB Garganas saying that turmoil will ease after the publication of audited bank balance sheets and Noyer warning that the European economy may be more damaged by the US housing slump than initially forecast.  Service sector PMI is due for release tomorrow.  The problems in the financial sector could weigh on service sector growth. 

British Pound: Next Central Bank to Surprise?

The British pound continued to range trade as economic data provided little guidance on whether the Bank of England will be the next central bank to lower interest rates this week.  Like the Bank of Canada rate decision, going into the BoE rate decision, only 60 percent of traders expect the central bank to make a move.  Although economic data is also weakening with retail sales and construction sector PMI falling last month, producer and consumer prices are on the rise.  Therefore the BoE does not have as much flexibility as the BoC to lower interest rates.  It’s a tough call though because UK LIBOR rates are skyrocketing and the central bank may want to measures to offset that pressure by easing monetary policy.   Service sector PMI due out tomorrow could help clarify what the central bank may do on Thursday. 

Further Losses in the Dow Leave Carry Trades Mixed

The Japanese Yen crosses are mixed today as the Dow continued to give back some of last week’s impressive gains.  The only piece of Japanese economic data released last night was the monetary base, which was stronger than expected.  There is no data scheduled for release tonight, but that does not mean there will not be any action in the carry trades.  Australia and New Zealand’s interest rate decision could shift demand for high yielders, which will have its impact on the Japanese Yen.  Also, keep an eye on the Dow because the decline today stopped short of an important technical support level.  If that level is broken, we could see sharp losses in US equities.  

By Kathy Lien, Chief Strategist of DailyFX.com

 

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