Rate Decisions to Drive FX

Article by Korman Tam of forexnews.com

Central bank policy decisions will dominate the headlines this week particularly given the drastic rate cuts from the FOMC recently. While the Fed has slashed its benchmark lending rate by 125-basis points within the past two weeks to 3.0%, the dollar has not sold off as sharply as would be anticipated given the interest rate gap. Last Friday's dismal non-farm payrolls number, which revealed a loss of 17k jobs - its first since 2003, failed to prompt a sustained sell-off in the greenback. With much of the US economic malaise and additional rate cuts priced into the dollar, traders will focus on the direction of central bank policy moves this week.

Yen as Proxy for Risk Aversion

The US stock market has lost over 10% of its capitalization since reaching an all-time high in October of last year. Meanwhile, the Japanese Yen has climbed at least as much in proportional terms since bottoming out around the same time. Coincidence? At least one analyst doesn't think so. Because of the steadfast popularity of the carry trade, the Japanese Yen appears to have developed an inverse correlation with the US stock markets. The reasoning is actually quite simple. When aversion to risk is low, investors borrow in Japanese Yen and make investments denominated in other currencies, the Dollar for one. When risk-aversion increases, as it has in the current economic environment, investors have been quick to close out their carry trade positions, causing the Yen to rise.

Read more here: Marekt Correlation

Fed Lowers Rates...Again

Last January 30, the Federal Reserve Bank lowered interest rates for the second time in as many weeks, bringing its benchmark federal funds rate down to 3.00%. The Fed has now lowered rates by 2.25% since August. The move came as a relief to investors, who now see that the Fed is serious about preventing the economy from slipping into a full-scale recession.

However, it remains to be seen whether the rate cuts will provide the necessary boost to the economy or instead prove too little too late. As far as the Dollar is concerned, the rate cuts carry two (conflicting) implications. On the one hand, the economy and stock market could rally, which would likely be matched by a Dollar rally. On the other hand, the interest rate differential between the US and EU is now a 1% and risk-averse investors hungry for yield will be hard-pressed to justify shifting capital to the US.

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The Current Market Sentiment

This article is from FX Consultant Walid Salah El Din, which mirrors my own personal views of the current market situation.

By God's will, we wait for the US fed's rate decision later this week. After last week surprising .75% interest rate cut, we want to listen to the fed's language to know how far they can go after this recent cut. The market is expecting further cuts but it is split between whether there is another cut or not this week.

The UK growth pace is expected to be negatively impacted too by the same crediting problems of US after the sub-prime mortgage undiminished problems and the increased probabilities of recession in US but it's became clear to the market that the inflation upside risks is to tackle the MPC following to the Fed's for spurring investment bringing back the risk appetite and trust in the equity markets.

The growth worries are looking softer in EU and the ECB ensured that they see this or want this! It is not clear yet! But the expectation of a hike later this year has diminished after the ECB member Mersch's comments that there are signs of growth weakness but the ECB has not discussed but 2 options not 3 which are a hike or a keep of the current interest rate but Last week disappointing 52.0 service PMI ensured that there actually signs of growth weakness amid uneased yet inflation risks and high energy and commodities prices can threat the price stability in EU.

the Japanese yen can keep gaining from this current interest rate outlook differential tightening, the mistrust in the stock market especially after the huge loss of citigroup 4th quarter amid the crediting problems and the increased expectations of a US recession can spread out especially, If the US growth could not get uses of the easing package of 150 Bln Bush's plan and the fed monetary easing.

By God's Will, The gold rates could keep its gains after the surprising .75% Fed's cut getting back above 900 again versus the greenback as the current market prospects of further interest rates cutting persisting offering much more funds to the credit and financial markets which can add to the gold value amid uneased oil and commodities prices. The recent US inflation rates have reached the fastest pace in over two years last November and were mild last December as Dec Core CPI came as expected .2% m/m and 2.4% y/y. the stagflation case is still possible which can add to the gold value too.

FOMC Emergency Rate Cut

The FOMC caught markets off guard on Tuesday with an unexpected inter-meeting 75-basis point rate cut, bringing the Fed Funds rate to 3.5%. In the accompanying statement, the Fed cited “weakening of the economic outlook and increasing downside risks to growth” for the aggressive move. The greenback quickly sold off against the euro and sterling after the announcement and remains weak heading into the Wednesday session.

The Fed’s easing today marks the largest rate cut of this stature since 1982 and first inter-meeting move since the September 11th attacks. The Asian equity bourses took solace in the FOMC’s aggressive action to stave off a US economic recession, with Tokyo’s Nikkei index rallying 3.35% and Hong Kong’s Hang Seng up 7.18% by midday. With the scheduled policy deliberating meeting just a week away, I expect another 50-basis point rate cut when the Fed announces its decision next Wednesday.

Volatility Drives Yen

As Asian capital markets crash in unison, the Japanese Yen is rising at its fastest pace in years. Taken out of context, that sounds like a contradiction, since a positive correlation typically obtains between the strength of a nation's economy, capital markets, and currency. However, the Yen is unique, as most forex traders are doubtlessly aware. The Yen rises and falls with the whims of the carry trade, which in turn is tied closely to volatility. And in case you haven't noticed, global capital markets are seesawing to such an extent that by some measures, volatility levels have reached a nine-year high. One analyst has drawn a parallel between the current credit crisis and the 1998 Asian economic crisis, which also produced a Yen rally.

Read more: History Points to a Yen Rally

Asian, European, and American stocks has dropped in 2 consecutive days. And its not just an ordinary drop. It is reported that Dow Jones reaches its lowest low of/since 1991.

EUR/CHF plunged 891pips since Oct. 11 last year. Surpassed the record low of Aug. 2001 with 868pips. Again, please stay out of the correlation hedge for now. Wait for things get back to normal.