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US Dollar: What Impact Will the Federal Reserve’s Rate Decision Have?

By Terri Belkas
28 October 2008 22:26 GMT

•    US Dollar: What Impact Will the Federal Reserve’s Rate Decision Have?
•    Euro: Fate Lies In the Fed’s Hands, But German CPI May Raise Speculation of ECB Rate Cut Next Week
•    British Pound Rallies Over 2%, Suggesting A Bottom May Be In Place
•    Japanese Yen Plummets on Nearly 11% Surge in US Stock Markets


US Dollar: What Impact Will the Federal Reserve’s Rate Decision Have?
The US dollar strengthened for much of the morning, only to plunge at the end of the day as a nearly 11 percent surge in US stock markets drained demand for safe-haven assets. US economic data released at 10:00 ET worked in favor of dollar weakness, but the greater trend was the rise in equities and risk appetite. The Conference Board's measure of US consumer confidence plunged to a record low of 38.0 from 61.4, signaling that sentiment amongst American households is the worst in over 40 years (records go back to 1967). Looking at a breakdown of the report, it is clear that a recession in the US - which should be confirmed by Q3 GDP figures on Thursday - is being felt by consumers, as those surveyed indicated that current economic conditions had deteriorated and that jobs have become increasingly hard to get. Furthermore, their outlooks for the next 6 months indicated that they thought business conditions would worsen, fewer jobs would be available, and income would decrease. Given the nine consecutive months of job losses we've seen reflected in US non-farm payrolls, it isn't incredibly surprising to see consumer confidence turn so pessimistic. What is unexpected, though, is the rise in 1-year inflation expectations to 6.9 percent from 6.2 percent. This is the highest level since July, when commodities were at their peak, and these indications that consumers still anticipate that prices will rise despite the rapid drop in energy and food costs puts the Federal Reserve in a tough position, especially since they are forecasted to slash rates by 50 basis points on Wednesday to 1.00 percent.

Nevertheless, like 43 of the 69 economists polled by Bloomberg News, I think we will indeed see the fed funds rate at 1.00 percent tomorrow afternoon at 14:15 ET, which is what fed fund futures are currently pricing in. Indeed, following the last FOMC meeting on October 8 when the bank participated in a coordinated rate cut with the European Central Bank and Bank of England, among others, the Committee acknowledged cooling inflation pressures and significant downside risks to growth, all of which appears to be coming to fruition. The US dollar is likely to pull back on the announcement of a 50 basis point cut, especially if the news boosts investor sentiment and US stock markets rally further. However, if the Fed surprises with a less aggressive 25 basis point cut, the US dollar could gain on safe-haven flows while equities plummet on the disappointing news.

Related Article: How Will A Rate Cut And Recession Effect The Dollar's Reserve Status?

Euro: Fate Lies In the Fed’s Hands, But German CPI May Raise Speculation of ECB Rate Cut Next Week
The euro finally broke out of its recent range of 1.2350 - 1.2585, and even managed to rally above 1.2700 on Tuesday, but the move had little to do with European fundamentals and instead marked a shift in risk trends. Lately, EUR/USD has been hit hard as risk aversion drives safe-haven assets like the US dollar and Treasuries higher. However, the bounce in the pair today - along with the nearly 3 percent jump in crude oil and the 10.88 percent surge in the Dow Jones Industrial Average - suggests a pick up in risk appetite. Looking ahead to Wednesday, the Fed’s rate decision will likely determine where the financial markets go, and a reduction in line with or more than expectations is likely to lead EUR/USD even higher. However, there will also be event risk for the euro specifically, as German inflation figures will hit the wires. Indeed, German CPI is forecasted to slow to a 6-month low of 2.4 percent in October from 2.9 percent. Such a decline would signal that price pressures throughout the Euro-zone are cooling as well, raising the risks that the European Central Bank will cut rates when they meet next week.

Related Article: Euro Economic Outlook Is Bleak, But Currency May Still Gain This Week

British Pound Rallies Over 2%, Suggesting A Bottom May Be In Place
The British pound gained more than 2 percent against the greenback on Tuesday, though the bulk of the move came in the afternoon as a surge in the US stock markets signaled a broad rise in demand for “risky” assets like carry trades. Indeed, with interest rates in the UK at a relatively high 4.50 percent, GBP/USD essentially qualifies as a “carry trade” pair. Looking ahead to Wednesday, there is limited event risk on hand for the British pound itself, though UK consumer credit figures are anticipated to reflect waning demand for loans and mortgage approval could slip lower. However, these numbers aren’t likely to be very surprising as tight credit markets have had a broad impact on banks, businesses, and consumers alike. The bigger risk for GBP/USD will come from the Federal Reserve’s rate decision, especially as it should have a huge impact on risk appetite in the market.

Related Article: British Pound Dives On UK Recession News - Rebound Potential?

Japanese Yen Plummets on Nearly 11% Surge in US Stock Markets
Forex carry trades rocketed higher on Tuesday, as the Japanese yen tumbled more than 10 percent versus high-yielding currencies like the New Zealand dollar and Australian dollar, while falling 5.6 percent - 7.5 percent against the US dollar, euro, and Canadian dollar. Indeed, risk appetite picked up in a big way as the CBOE’s VIX Index dropped to 66.96 from Monday’s close of 80. While this is still historically high, leaving bullish potential open for the Japanese yen, there is a chance this improvement in investor sentiment could last through the near-term. However, this also depends on the Federal Reserve: if the central bank cuts rates in line with or more than expectations, stocks markets and forex carry trades could rise while the US dollar and Japanese yen would likely drop. On the other hand, if the Fed’s announcement disappoints traders, risk aversion could easily come back into play.

Related Articles: Japanese Yen Will Hold Its Gains As Long As Risk Dominates, Australian Dollar Losses May Continue As Very Little Support Remains

**For a full list of upcoming event risk and past releases, check out the DailyFX Calendar

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Written by Terri Belkas, Currency Strategist for DailyFX.com
E-mail: tbelkas@dailyfx.com

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.
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28 October 2008 22:26 GMT