Monday, August 04, 2008

08/04/2008 10:05 AM

FX Strategy & FOMC Preview

FOMC Statement Seen More Dovish, but Watch Plosser’s Vote

Tomorrow’s Fed decision is widely expected to hold rates unchanged at 2.00%. We expect the FOMC policy statement to sound more dovish on the growth front while maintaining the same degree of hawkishness towards inflation. The 19% oil price decline coupled with the steady deterioration in employment and housing figures is an undisputable combination for the FOMC to issue a more dovish (or less hawkish) statement, which would be slightly dollar negative. Such conclusion is easily gleaned from Fed chairman Bernanke’s semi annual testimony to Congress last month where he stated “significant downside risks” for the economy, an explicit change from his prior speech in June where he said “the risk that the economy has entered a substantial downturn appears to have diminished over the past month or so”.

Nonetheless, the dollar could rally (and stocks decline) despite a more dovish statement in the event that Philadelphia Fed president Charles Plosser joins Dallas Fed’s Richard Fisher in voting for a rate hike. Assuming that Fisher repeats his June vote in favor for a 25-bps rate hike and Plosser to convert his hawkish rhetoric of the last months into a rate hike vote, the dollar could rally on the thinking that the FOMC hawks are growing in numbers. We still think the hawks are well outnumbered by the moderates.

EURUSD

The last three consecutive weekly declines in EURUSD reflected the onslaught of negative data from the Eurozone as well as the sharp decline in energy prices. Despite the euro’s 5-cent decline, the currency remains at the center of its 5-month consolidation zone. There are two main forces that would trigger further euro losses: 1) prolonged Eurozone data weakness coupled with peaking inflation; and: 2) increased chances of a Fed rate hike. None of these has occurred. In fact, the contrary has taken place, as Eurozone CPI edged up to a fresh record high of 4.1% according to the flash July estimates from June’s 4.0%. Fed funds futures have substantially curtailed odds of a September 25-bp hike and of a similar move by year-end. Recall that immediately after the June FOMC announcement, futures had priced as much as a 48% chance of an August rate hike and a 65% chance of a September rate hike. We expect these unrealistic probabilities to continue dwindling for the remainder of year’s meetings. We also stick with our forecast that the Fed will cut rates by 50 bps by year-end.

While many market pundits reiterate the notion that the US will beat the Eurozone to a recovery, we remind that the US downside risks are highlighted by a combination of deteriorating macroeconomic dynamics and heightened losses on the banking and credit front. Meanwhile, in the Eurozone, the slowdown is largely limited to cyclical and plain vanilla macroeconomic dynamics such as consumer demand/confidence, employment and manufacturing orders. Despite sub-prime related losses with some European insurers, the problems of homeowners’ negative equity and foreclosures have not caused a drag on demand as the case has shown in the US. Neither the macroeconomic woes nor the ensuing bear market in Eurozone bourses has posed ominous questions for the foreign financing of Eurozone deficit. The foreign exchange implications of these analyses are also enforced by the continued (but gradual) diversification in central bank and sovereign wealth fund currency portfolios, into assets denominated in euro, sterling and East Asian currencies. Market players must be reminded that any semblance of economic improvement on the global arena could eventually be interpreted as fewer obstacles for further ECB tightening. We expect the euro to cement a bottom near $1.5450 before gradually but recovering towards the low 1.5600.

USDJPY

The ongoing failure of USDJPY to break above the 108.30-40 highs despite prolonged Japanese weakness is a result of renewed erosion in global equities and reduced risk appetite, as well as diminished market expectations of a Fed hike. Japanese policy makers are being forced to come up with their own program of economic stimulus as the government and central bank downgrade their overall economic assessment. The 1.9% annual June inflation reading was the highest in 10 years, which is likely to continue supporting JGB yields and the currency.

Reports that Kuwait's sovereign wealth fund (Kuwait Investment Authority) plans to triple its investments in Japan investments to $48 billion, by investing $15 to $16 billion are consistent with sovereign wealth funds’ need to reduce the proportion of their dollar holdings. This is necessary so that the funds could cushion the foreign exchange hit from any currency revaluation against the US currency. Kuwait is the only GCC state to have ended its peg to the US dollar by shifting towards a currency basket. Although the dollar accounts over 80% of the basket, the Kuwaiti Dinar has been revalued by more than 8% against dollar.

August has proven to be a strong month the USDJPY over the past 15 years. Repatriation by Japanese funds and corporations ahead of the end of the first half of the fiscal year in September is likely to accelerate yen gains triggered by renewed episodes of dried up risk appetite. USDJPY remains just below its 50-week moving average (108.30), a technical landmark that the pair has failed to breach since June 2007. We do not expect Tuesday’s FOMC statement to have any cause for a dollar rally. The retreat in energy prices is another reason we’re unlikely to see Philadelphia Fed’s Plosser to vote for a rate hike alongside Dallas Fed’s Fisher. Any intermittent break of 108.30 is seen capped at 108.50. Downside to gradually ensue until the bear takes over and drags the pair towards 104.50, albeit not in the same violent pace of last summer but in a similar fashion as in February-March of this year.

GBPUSD

The British pound’s broad losses of the past three weeks comprise are a return to the norm following a brie appreciation in June. The avalanche of record low figures in housing and retail related data shows not only the worst is far from over but also the UK economy is gradually sinking into recession territory. Although an economic contraction may not be limited to the UK, UK interest rates remain the highest in the G7, which makes them vulnerable to renewed policy easing despite soaring inflation.

Although the Bank of England is guided by an inflation target of 2.0%, such constraint is imposed by the government, which may encourage policy easing for economic and political purposes. This not the case with the ECB which has full authority over setting and pursuing its inflation mandate. Although UK CPI stands at a record annual 3.6% in June, the core CPI is 1.6%, showing the biggest divergence between headline and core in the G10. The Bank of England has already cut interest rates by a total of 50 bps this year to 5.00%. We expect another 50 bps this year, followed by 25 bps in Q1 of next year. We expect the downtrend in the pound to remain firmly cemented, paving the way for 1.9550 by month end.

Analyst Bio

Ashraf Laidi, Chief FX Analyst at CMC Markets, oversees the analysis and forecasting functions of key currency pairs as well as decisions and trends of the major global central banks. Mr. Laidi is also responsible for education and informing clients on the essential dynamics underpinning FX markets.

Prior to joining CMC, Mr. Laidi has worked for such varied organizations as the United Nations, the World Bank, and Reuters. Mr. Laidi regularly provides expert opinion to various electronic, print and the broadcast media outlets.

Mr. Laidi has appeared regularly on CNBC-TV, Bloomberg TV, the BBC and PBS’ Nightly Business Report. His insights also appear in the Financial Times, The Wall Street Journal, Barron’s, The New York Times, CBS Marketwatch, TheStreet.com, Futures Magazine and a host of other international publication.