U.S. Dollar: Fed Shocks With Discount Rate HikeU.S. DOLLAR: FED SHOCKS WITH DISCOUNT RATE HIKE
After the stock markets closed this afternoon, the Federal Reserve raised the discount rate by 25bp to 0.75 percent, sending the U.S. dollar sharply higher against all of the major currencies. Although the Fed went out of their way to say that this does not equate to a change in their monetary policy outlook, action speaks louder than words. Their decision to begin normalizing rates before the next central bank meeting indicates how hawkish they must be and how serious they are about tightening monetary policy. First, it is important to realize that the discount rate is different from the Federal Funds or overnight lending rate. The discount rate is the rate charged to commercial banks and other depository institutions on loans that they receive from the Fed while the Fed funds rate is the rate that banks charge each other for loans. By hiking the discount rate and not the Fed funds rate, the central bank has in essence, widened the spread. The Fed also shortened the terms of primary loans to overnight from 90 days. This is a game changer for the foreign exchange market and should lead to further gains in the dollar during the Asian and European trading sessions even if the U.S. central bank attempted to temper their comments by saying that their outlook for the economy and monetary policy is unchanged and that rates will remain low for an extended period. The most important takeaway is that the Fed is beginning to implement an exit strategy which is more than what many of the other central banks are doing and therefore this action will be extremely positive for the dollar. We expect the EUR/USD to break 1.35 in the near future.
U.S. Dollar Wins Both Ways
Over the past few weeks we have seen that regardless of whether currency traders focus on Greece or the Federal Reserve's hawkishness – the dollar wins. Until the sovereign debt problems in Europe are resolved, investors will be extremely reluctant to hold euros and the reaction to any bad news will probably be compounded simply because investors will attribute any slowdown in the Eurozone or other problems with the region to Greece. At the end of the day, the U.S. dollar is still a safe haven currency which means that it as long as investors remain nervous, the dollar should hold onto its gains. On the flipside, the more hawkish the Federal Reserve grows and the more positive surprises there are in U.S. economic data, the more attractive the dollar and U.S. investments become. This is why the dollar could continue to rise. Based upon the last IMM report, positions in the futures market has only recently shifted from net short dollars to net long which means that given the right circumstances (additional positive U.S. data or concerns about sovereign debt), some of the investors that are sitting on the sidelines could be tempted to buy dollars as well.
U.S. Data Preview and Review
Consumer prices is only piece of U.S. economic data that is due for release tomorrow and based upon this morning's producer price report, inflationary pressures are back. Although January tends to be a period of discounting for retailers, there was tremendous volatility in gas prices last month. At the beginning of the year, the price of a gallon of gasoline was approximately $2.60. By January 15th, it was $2.75. Although gas prices ended the month at approximately $2.68, higher prices during the month will certainly be reflected in the CPI report. Like import prices, producer prices were stronger than expected in the month of January. PPI rose 1.4 percent, pushing the annualized pace of wholesale price growth to 4.6 from 4.4 percent, the highest level since October 2008. However the more modest 0.3 percent rise in PPI excluding food and energy prices indicate that inflationary pressures stemmed primarily from higher gasoline and energy costs. Evidence of lower prices on women's apparel, passenger cars and computers indicates that weak consumer demand is still holding back price growth in other parts of the economy. The Philly Fed index rose from 15.2 to 17.6 which was marginally better than the market's 17.0 forecast while continuing claims were flat at 4.563 million. The final disappointment came from leading indicators which rose only 0.3 percent last month, a dramatic slowdown from the 1.2 percent rise in December. The deterioration in the labor market raises red flags about future job growth and confirms the Federal Reserve's prediction that unemployment will remain high. However based upon the FOMC minutes and recent comments from Bernanke, the drop in claims should not stop them from reducing the size of their balance sheet. The U.S. Treasury yield curve has steepened dramatically which means that bond traders are pricing in a stronger U.S. recovery.
EUR/USD: GREECE MAKES CHANGES, SIGNS OF SNB INTERVENTION
The surprise announcement by the U.S. Federal Reserve drove the euro to a fresh 9 month low against the U.S. dollar. Evidence that Greece may have falsified their statistics is really starting to agitate Germany, the largest country within the Eurozone. Chancellor Angela Merkel said yesterday afternoon that it is a scandal if banks helped Greece hide their deficit and warned that Greece may have reported false numbers for years. Such harsh criticism suggests that Germany may not be very willing to bailout Greece if needed. On their own front, Greece has replaced the head of their Public Debt Management Agency, Spyros Papanicolaou with Petros Christodoulou who is a prominent commercial banker. This is obviously an attempt to restore confidence even though it is normal for a new government to make changes. Greece may be on the back burner this week but the rise in their Credit Default Spreads indicates that investors remain nervous. German producer prices are due for release tomorrow along with PMI reports from the Eurozone and current account figures. If the PMI numbers are weak, traders will most likely blame the weakness on the problems in Greece, Portugal, Italy, Ireland and Spain. Meanwhile, a sharp and quick rise in EUR/CHF during the U.S. trading session sparked speculation of intervention by the Swiss National Bank. At 8:58 am NY Time, EUR/CHF jumped 48 pips in 60 seconds. This type move smells like intervention but the odor is not particularly strong because usually when a central bank intervenes we see moves that are usually in excess of 100 pips. The SNB has declined to comment which is typical. Switzerland's trade surplus also increased in January as exports rise by a faster pace than imports.
GBP/USD: POUNDED BY MORE DISAPPOINTMENTS
Of all the major currencies, the British pound fell the most against the U.S. dollar today. After yesterday's sharp rise in unemployment, the pound has been hit by another round of disappointing economic data. Mortgage approvals dropped to 49k in January as poor weather conditions prevented transactions from being completed. A recovery in the second half of the month failed to offset the decline in the first half. The country also had to borrow money in January for the first time in 77 years. Public finances printed a deficit of GBP11.8B in January compared to a surplus of GBP16.3B the prior month. January normally produces a surplus since government tends to receive tax payments from individuals and businesses. The only good news was the improvement in the CBI Industrial Trends survey which is a leading indicator for manufacturing sector activity. U.K. retail sales are due for release tomorrow and based upon the deterioration in the labor market and the smaller rise in the BRC retail sales monitor, consumer spending is expected to slow in the month of January. Another disappointment would only be salt on the wound for the U.K. and will undoubtedly push the British pound lower. The only saving grace would be that the market already expects a weak number.
USD/CAD: INFLATIONARY PRESSURES IN CANADA RISE
The Canadian, Australian and New Zealand dollars gave back all of their earlier gains following the Fed's announcement. Nonetheless prior to the breaking news, the Loonie led the way after inflation quickened at a slightly faster pace and price of oil soared. The host of the Olympic Games saw consumer prices rise at the fastest pace since November of last year, bringing the inflation target within the reach of BOC's target. This will put a strain on the central bank to raise interest rates if not for the fact that they have warned of no rate hikes until mid year. Core Inflation which excludes food and gasoline prices rose by 2 percent confirming that inflation is rising at a faster rate than previously predicted by the bank. The Bank of Canada predicted inflation to return to 2% by 3rd Quarter of 2010. Retail sales are due for release tomorrow and despite the sharp improvement in the labor market last month, the smaller rise in wholesale prices suggests that consumer spending remains weak. Meanwhile, New Zealand's Consumer Confidence index fell in February suggesting that the recovery will remain "gradual and guarded." Optimism for the Australian economy remains intact as Business Confidence rose to a 15-year high. Additionally, RBA's assistant governor Phillip Lowe stated that China's economy possesses a couple of decades of benefits for Australian economy. This evening RBA Governor Stevens is set to speak in front of House of Representatives Committee and any hawkish comments could drive further gains in the Aussie.
USD/JPY: BOJ LEAVES RATES UNCHANGED
USD/JPY hit a one month high after the Fed announcement. As expected the Bank of Japan left interest rates unchanged at 10 basis points. Nonetheless, the market was taken by surprise by the lack of any additional information coming from the BOJ. Central Bank Governor Shirakawa failed to discuss any extensions of its QE program. Yet, with deflationary spiral deep-rooted in the economy the probability of additional easing remains alive. The interesting phenomena coming out of the meeting is the BOJ's unwillingness to be guided by the central government. Financial Minister Naoto Kan among other policy makers called on the central bank to create an inflationary target. Despite the pressure from the government, Mr. Shirakawa showed clear intentions of not establishing any guidelines, claiming that "By focusing excessively on the movement of prices, policy makers failed to spot imbalances in the economy and financial system." On the economic front, Leading Index showed minor advancement while Coincident Index slipped marginally. Tokyo and Nationwide Department Store Sales continued to slide as consumers remain cautious with their spending. Rounding up the week for Japanese economic figures will be the release of All Industry Activity Index and Bank of Japan Monthly Report.
GBP/USD: Currency in Play for Next 24 Hours
The currency in play for the upcoming 24 hours is GBP/USD. Retail Sales are on tap from the U.K. at 9:30GMT or 4:30AM EST. Inflation figures will be released from the U.S. at 13:30GMT or 8:30 AM EST. Cable once again dropped into the Sell Zone which we established through the Bollinger Bands. The pair seems focused on testing the 1.55 level. The current level of support lies between this year's low of 1.5530 and the psychologically important 1.55 level. If support is breached expect the pair to make its way to 1.50. However, if the GBP/USD breaks out of the Sell Zone expect the latest swing high at 1.5800 to act as a level of resistance.