Forex

ECB Trichet's remarks hit the wires indicating his concern about excessive currency moves, which we believe could drag EURUSD to as low as $1.5250.
UAE Ponders Dollar Depeg, USDJPY Eyes Sub 100

After the dollar broke to a 5-year low of 101.38 yen on Friday, we see a 90% chance for the currency to drop under the 100 yen level as early as this week amid a combination of reduced risk appetite (broad declines in global bourses) and deteriorating interest rate differentials weighing on the US dollar as the Fed is expected to cut rates by at least 75-bps this month. Such a rate cut could take the form either via a 50-bp inter-meeting rate cut this week, followed by a 25-bp rate cut at its March 18 meeting, or the full 75-bp easing on March 18. (More on yen forecasts below) The other piece of piece of news weighing on the dollar is the announcement from the central bank of the United Arab Emirates that it will set up a task force at depegging its currency from the US dollar. The announcement implies that the UAE will move towards a basket of currencies, which would include a revaluation of the dirham-USD exchange rate, rather than simply revaluing its dollar peg. Abandoning the 100% dollar peg by the UAE will pressure Saudi Arabia into taking the decision as the public suffers from falling purchasing power, to the extent of triggering tensions across the Kingdom. The importance of these announcements is also underlined by an expected repricing of OPECs’ revenues in a basket of multiple currencies from solely a dollar-based pricing.

No Ordinary Recession

Earlier this month we stated our staunch disagreement with the emerging view in currency markets that the Fed’s aggressive rate cuts will bring to the dollar the same growth-driven rally as that of 2001-2. Late last year we made the call that the dollar would strengthen into the first half of Q1 2008 before retreating lower as the Fed will be forced to resume cutting interest rates to the extent of further driving real interest rates further below zero. Out of the several factors distinguishing the current environment from that of 2001 is the purpose of the Fed’s easing. The rate cuts of 2001-02 were driven by conventional dynamics of macroeconomic slowdown (cooling business activity, weak GDP growth, rising unemployment and falling equities). Today, the relatively untested Federal Reserve officials find themselves in uncharted territory highlighted by the following factors:

1. Rising Commodities & Falling Dollar Show no Ordinary Recession: The Fed’s task of shoring up growth is already being complicated by persistent inflationary pressures that are unlikely to abate as was the case in past economic contractions. In addition to record high commodity prices, the current recession is not accompanied by a strong dollar as in the last 3 recessions. The unfolding commodity and currency dynamics are contributing to the stagflation-like conditions that will exacerbate the steepening of the yield curve and the dilemma of the Federal Reserve.
Interestingly, the Bernanke may have already hinted to us we’re already in a recession he said today’s; conditions were more challenging than in 2001. Despite the Fed’s stepping up of liquidity operations, it will be forced to slash interest rates to 2.00% by end of Q2 and we see about a 70% chance of 1.50% fed funds rate by end of year. The payroll report is an indisputable negative for the already damaged dollar especially considering the ECB’s tacit support for its record-high euro as it uses currency policy to contain inflationary pressures rather than monetary policy.

2. A pronounced shortage of money market liquidity (requiring liquidity injections beyond those of Sep 2001), unwillingness of lending by commercial banks, uncertainty regarding the size of remaining write-downs and the resulting impact on banks’ rating, capital cushion and bottom line. Tightening lending requirements for private households and business are also expected to weigh on overall capital formation and aggregate demand.

3. The macroeconomic fallout from:1) falling prices of new and existing homes on construction and consumer spending 2) falling sales of new/existing homes 3) increased layoffs in housing-related industries, banking/finance and manufacturing jobs, will impose a severe test on consumer spending once the post-holiday sales season is behind us.

The repercussions on employment will only get worse as the latest four employment reports have shown. In Friday’s February jobs report, the 3-month moving average of payrolls fell to -15K, the first negative figure since August 2003. Payrolls in the once strong services sector fell to a 3-year low of 26K, well below their 3-month average of 57K.

Fed funds futures are now pricing more than 30% chance of a 2.0% rate by June, which has been our assessment since Bernanke’s speech last week. The steepening yield curve is further widening the 10-2 year spread to 210 pts, largely due to declines on short end rather than increases on the long end as markets price more than 50% chance of a 75-bp rate cut this month. This also means that the markets’ pricing expectations are allowing for the probability of an inter-meeting rate cut prior to the March 18 meeting.

Yen Awaits Rate Cuts, Equity Corrections and Interventions

Aside from the aforementioned reasons to further yen strength, the currency has displayed strength during the month of March in light of pre-fiscal year-end repatriation by Japanese firms and institutions. USDJPY ended lower in 7 of the last 10 years. Only a surprise Fed intermeeting rate cut is seen as the likely event to trigger a short-lived downward reversal in the yen against most currencies, but that also means further dislocation in the dollar’s interest rate differential. Markets will continue shrugging jawboning remarks from Japanese officials until policy makers are forced to threaten operational intervention, which has not been done since early 2004. One main reason Japanese officials have stayed away from intervention is the avoidance of accusations of a double standard, as the industrialized world has

USDJPY will attempt to take out the 102.00 figure onto 101.60 and call up 101.30. Upside remains capped at 102.70. An inter-meeting rate will likely boost the pair towards 103.30-40.

Euro Eases Momentum But Remains Supported

Despite Friday’s poor jobs report, the dollar had lifted off its lows after the Federal Reserve announced it will raise the amount of liquidity in its TAF auctions to $100 bln to "address heightened liquidity pressures in term funding markets". Separately, the ECB had issued a statement indicating it is willing to provide extra dollar liquidity, as it did back in January 22 and Dec 12. The Fed also announced it will conduct its first 28-day term repo operation today and make it into a weekly basis. Such bold measures were interpreted by currency traders to reduce the likelihood of an inter-meeting rate cut, thus sparing the dollar of further erosion.

But the euro’s momentum remains in place especially after ECB president JC Trichet reiterated the need to combat inflation without addressing the euro’s latest ascent. Chances of further euro pullback may extend after tomorrow’s release of the Mar ZEW survey (5 am EST) expected to down to -42 from 41.4 and current sentiment at 30 from 33.7.Support emerges at $1.5320, backed by $1.5280, with resistance seen pushing towards 1.5400. Key pressure stands at 1.5430.

Sterling Eyes $2.20250

Sterling is unfazed by lower softer producer inflation and weaker manufacturing. UK PPI slowed to 0.2% last month versus expectations of 0.4% following a revised 0.9%, while industrial Production fell 0.1% in Jan, matching the Dec decline. Separately, UK Chancellor Darling is reported to have agreed to a deal lowering the burden of US citizens working in the UK under a new tax proposal demanding non-Citizens to pay an annual £30K tax on overseas earnings.

Cable gains firm support at the $2.0150 trend line, eyeing upside at 2.0250. A Fed inter-meeting rate cut should breach above 2.0250, and onto 2.0300.

GBCHF remains inside its consolidation phase capped at 2.0750 but may push towards 2.08 in the event of a Fed cut. Downside pressure expected to reemerge, calling the 2.0550 and 2.0490.