Which Currencies Fail to Join the Rally in Equities?

Last Updated 10/20/2008 5:16:45 PM EST (GMT +5)

THE STORIES IN THE CURRENCY MARKET

• USD: WHICH CURRENCIES FAIL TO JOIN THE RALLY IN EQUITIES?
• EUR: WEAKENS ON FEAR OF LEHMAN EXPOSURE
• GBP: SELLS OFF DESPITE MORE SIGNS OF INFLATION
• CAD: 50BP RATE CUT EXPECTED
• AUD: PRODUCER PRICES SEE BIGGEST RISE IN 10 YEARS
• NZD: BUSINESS PMI REMAINS IN CONTRACTIONARY TERRITORY
• JPY: CARRY TRADES RECOVER AS VOLATILITY FALLS FROM RECENT HIGHS

EXPECTATIONS FOR UPCOMING FED MEETINGS

CURRENT US INTEREST RATE: 2.00%				Traders lean towards 25bp cut next week
	10/29 Meeting	12/16 Meeting
NO CHANGE	0.0%	0.0%%
CUT 25BP	58.0%	55.8%
CUT 50BP	42.0%	42.6%
CUT 75BP	0.0%	1.6%

WHICH CURRENCIES FAIL TO JOIN THE RALLY IN EQUITIES?

For the past few weeks, currencies have trailed equities, but today we have only seen limited appreciation in the high yielding currency pairs despite the 400 point rally in the Dow. Even though the US dollar and the Yen sold off against the Australian and New Zealand dollars, it actually gained strength against the Euro, British pound and Japanese Yen. The big story today was the comments from Ben Bernanke who alluded to the need for further stimulus. Leading indicators also increased for the first time since April, helping to fuel the optimism in the financial markets.

October 21: Lehman Brothers CDS Settlement

However with the lack of any major US economic data on the calendar this week, the big event risk for the stock market and the US dollar is the Lehman Brothers’ Credit Default Swap settlement on Tuesday. The fear that European banks may be forced to pay out on the default protection has prevented the Euro and British pound from rallying despite the recovery in US stocks. The estimated payout on the CDS could be as high as $365 billion, more than half of the US government’s $700B bailout plan. The settlement should be most if not all in US dollars, which is why there has been a strong demand for dollars against the next 2 most actively traded currencies. If the CDS settlement triggers no bankruptcies, then the stability that we are beginning to see in the financial markets may last.

The sheer relief that there has been no negative news this weekend has helped the stock market and high yielding currencies recover. The liquidity that central banks have pumped into the financial markets is also finally having an effect on the credit markets. Everything from 3 month LIBOR spreads to the TED spread and currency volatilities have fallen since Friday and most of these indexes are down sharply from last Monday. This shift indicates that banks and other counterparties are becoming less risk averse and more willing to lend to each other which helped equities and carry trades rally.

Is $700B Not Enough?

In Bernanke’s testimony on the budget before the House today, he talked about the need for another stimulus plan given the strong possibility of a deeper slowdown in the US economy. He said that the additional stimulus should be decided by elected officials and should come at a time when the economy is the weakest. The pros and cons of more government spending could be argued extensively and the White House has already indicated that they are open to the idea.

However for the currency market, Bernanke’s comments about a second stimulus plan reflect his continued concerns about the US economy. This bias was echoed by Atlanta Fed President Lockhart who said that economic weakness will last well into 2009. Going into next week’s interest rate decision, this suggests that the Fed will cut interest rates; the only question is by how much.

BANK OF CANADA INTEREST RATE DECISION: WHAT TO EXPECT

The biggest event risk on the economic calendar tomorrow is the Bank of Canada interest rate decision. Having fallen more than 15 percent against the US dollar since the beginning of the month, the price action in the Canadian dollar suggests that traders are banking on more easing by the BoC. However, given that recent economic data has not been particularly weak and this would be the second rate cut this month, the central bank could opt for a smaller move. Although most of economists expect the Bank of Canada to cut interest rates tomorrow by 50bp to 2 percent, the forecasts are hardly unanimous as 9 expect a rate cut of 25bp or less.

The Ups and Downs of Canadian Economic Data

Indicator	August	Sept	Change
Unemployment Rate	6.10%	6.10%
Net Change in Employment	15.2K	106.9K
Ivey Purchasing Managers Index	51.5	61.0
Housing Starts	211.0K	217.6K
Retail Sales MoM	0.50%**	0.10%*
Consumer Price Index MoM	0.30%**	-0.20%*
Gross Domestic Product MoM	0.10%**	0.70%*

As illustrated by the movement of the Canadian dollar, traders have become increasingly unwilling to buy the currency in the wake of the global economic slowdown. However the fact of the matter is that numbers released from Canada have not been nearly as dreadful to warrant such weakness, leaving doubt as to how dovish policy makers will be during tomorrow’s meeting. The employment situation has been quite upbeat in Canada. In September, Canada reported record job growth that was 10 times better than economists expected. The IVEY Purchasing Managers Index, an important measure of business optimism also increased from 51.5 to 61 this month. The only question is what this means for retail sales, which is due on Thursday. Consumer prices have eased, giving the BoC more room to cut, but if strong employment translates into strong spending, the central bank may want to be more conservative with easing monetary policy so that they have more ammo for further action in the coming months.

Implications for the Canadian Dollar

Therefore the greater risk for the Canadian dollar would be the central bank under-delivering. A 50bp rate cut would push the CAD lower but not by much, especially if it is accompanied by more neutral comments. A 25bp rate cut on the other hand could turn out to be CAD positive. With the outlook for the global economy still uncertain, the BoC may want to under-deliver now and over-deliver later if needed.

Meanwhile Australian producer prices were much stronger than the market expected, taking the Australian dollar above 70 cents. New Zealand service sector PMI and credit card spending were softer than the market expected. If consumer prices ease as well, it would validate the market’s expectations for a full percentage rate cut by the RBNZ later this week.

EURO WEAKENS ON FEAR OF LEHMAN EXPOSURE

As indicated in the dollar portion of our commentary, the main reason why the Euro and British pound has failed to rally today was fears that European banks may have been big sellers of protection on Lehman Brothers. This morning, ING announced that they have received a EUR10 billion injection from the Dutch government. The French Economics Minister also announced that the government will be injecting EUR10 billion in French banks like Credit Agricole, BNP Paribas and SocGen. Coming 24 hours before the Lehman settlement, these liquidity injections certainly raise fears about the exposure of European banks. If any European banks come up short, expect more weakness in the Euro. Besides that, the rally in oil and the stronger than expected PPI report from Germany were Euro positive. There are no Eurozone data due for release tomorrow but Switzerland will be reporting their trade balance.

BRITISH POUND SELLS OFF DESPITE MORE SIGNS OF INFLATION

The British pound gave back all of its earlier gains as market whipsaws become the staple of currency price action. Recent economic data suggests that inflation remains a problem in the UK. Recent PPI and CPI numbers have hinted at such a development, while today’s hotter than expected M4 Money Supply has added some validation to these findings. Economists still expect the recent pull-back in energy prices to ease inflation concerns which is why growth will undoubtedly remain at the top of the BoE’s problems. The only economic data due from the UK tomorrow is the CBI Quarterly Industrial Trends, a survey of manufacturing conditions. It is likely that because of weak Industrial Production, reported earlier this month, the figure will not indicate an approaching turnaround in the manufacturing sector.

CARRY TRADES RECOVER AS VOLATILITY FALLS FROM RECENT HIGHS

Previous gains in USD/JPY have been largely extinguished despite a rallying DJIA. After being up 100 points, USD/JPY is now struggling to maintain positive territory. Crosses are rallying as the VIX falls almost 20% off recent highs. Risk appetite seems to be regained with the Dow’s rally, at least for the moment. NZD and AUD rose more than 100 pips. Although no meaningful data has been released from Japan today, tomorrow we are expecting the All Industries Activity Index. With both Japan’s exporting and domestic sectors weakening, as indicated by the weaker than expected Trade Balance and Tertiary Index, such a report can be a resoundingly negative figure.

USD/CAD: Currency in Play Over the Next 24 Hours

USD/CAD will be our currency in play over the next 24 hours as the Bank of Canada has its rate decision at 9:00 am ET or 13:00 GMT.

The rally in USD/CAD today reaffirms its position in the buy zone, which we determine using by Bollinger Bands. Support and resistance lines were determined by drawing Fibonacci levels from the congestion zone in late June of 2003 to the lows of late October 2007. The most immediate resistance lies at the 61.8% retracement at 1.2226. This level corresponds well with a congestion period in early 2005. Support lies at the one-standard deviation Bollinger band, which is near the 10-period SMA. This level is further strengthened by the 50% retracement lying at 1.1621. Unless that level is broken, expect further gains in USD/CAD and a possible test of the October 1.2127 high.

About The Author

Lien has extensive knowledge within the interbank market, particularly in trading spot FX and options. She has written for numerous publications, is frequently quoted on financial media outlets, and is the author of several books, including Millionaire Traders. Read more >>