US Dollar Gets a Boost from Fannie/Freddie Intervention

The US government’s seizure of Fannie Mae and Freddie Mac has provided a boost to the US dollar and carry trades on Monday, and has received applause around the world from Federal Reserve Chairman Ben Bernanke to European Central Bank President Jean-Claude Trichet, who called the move a “welcome decision.” Indeed, many have taken the intervention as the answer for the ailing US housing sector and financial markets. While the operation of Fannie Mae and Freddie Mac is good for the trading of mortgage-backed securities, in that there will be a party willing to buy the risky assets, it does not mean the values of them will improve. In order for these values to rise, US property values will need to increase first and there is no single solution for this. In reality, another major factor working against a recovery in housing is the slowing in the broad US economy, especially given last week’s worse-than-expected labor market reports. US non-farm payrolls (NFPs) fell 84,000, marking the eighth consecutive month of job losses in August, while the unemployment rate picked up to a 5-year high of 6.1 percent. Nevertheless, Credit Swiss overnight index swaps (OIS) are still pricing in over 50bps worth of hikes by the Federal Reserve within the next 12 months as the Federal Open Market Committee said during their last meeting that "the next policy move would likely be a tightening," though they did specify that any changes would "depend on evolving economic and financial developments.” Overall, I think this US dollar rally stemming from the Fannie/Freddie news is one to be leery of, and given the vastly overbought nature of the currency, we may be nearing a point where risk/reward warrants selling the greenback.

Japanese Yen Falters as Traders Return to Carry Trades

In the aftermath of the news of the US government’s seizure of Fannie Mae and Freddie Mac, the US dollar wasn’t the only currency to react strongly. Indeed, the Japanese yen finally pulled back against many of the majors, especially the high-yielding New Zealand dollar and Australian dollar, as traders saw the announcement as a green light to pile into carry trades. However, as we mentioned in our discussion of the US dollar, traders should be leery of these moves as the ultimate benefits of the GSE bailout (Government Sponsored Enterprise) may be limited for the financial markets and US housing sector. In Japanese economic news, the Eco Watchers survey of business conditions fell to a nearly 7-year low of 28.3 from 29.3. With wage growth slowing and the Japanese economy on the brink of recession, it is unsurprising to see that businesses are less optimistic about their prospects going forward. Nevertheless, this news really had little bearing on Japanese yen price action, as our latest forex correlations report shows that carry trades and the DJIA have increasingly been moving in lockstep (though the correlation is not as high as it was in 2007). Going forward, the Japanese yen will continue to depend on the status of risk appetite in the market, and the evolution of the Fannie Mae/Freddie Mac story will certainly be one worth following.

British Pound Experiences Heavy Volatility Trading in Massive 500 Point Range

Trading in the British pound had more to do with US dollar price action, but the moves were notable nonetheless. GBP/USD managed to trade in a nearly 500 point range of approximately 1.75 – 1.80, but ultimately ended the day by consolidating in a smaller range of 1.7550 - 1.7625. Looking at the data on hand, the UK producer price index reflected declines in both input and output prices during the month of August, as the former fell 2.0 percent and the latter slipped 0.6 percent, marking the sharpest drop since record-keeping began in 1986. The declines were due primarily to a reported 4.8 percent plunge in petroleum product prices, but energy was not the sole factor as even core output prices slipped 0.1 percent. Overall, the data suggests that the Bank of England may be able to let their guard down sooner rather than later when it comes to inflation risks, especially since the central bank is already grappling with the issue of a rapidly deteriorating economy. This is much of the reason why Credit Suisse overnight index swaps are pricing in nearly 100bps worth of rate cuts by the Bank of England over the next 12 months, and if the official UK CPI numbers (due to be released on 9/16) signal that inflation is not accelerating as quickly as they expected, the central bank could start reducing interest rates before year-end. Thus, from a fundamental perspective, downside risks remain for the British pound. However, the currency is also greatly oversold, and as Senior Strategist Jamie Saettele notes, the British pound could be nearing a turning point.

Euro Ends Day Down Nearly 300 Points From Intraday High

The euro collapsed 300 points from the intraday high during the European and US trading sessions to end the day near 1.4150 as investors bought up risky assets and signaled confidence in US assets. There was no European data on hand, but there was central bank commentary on hand that would normally provide a bullish spark for the euro. Indeed, European Central Bank Executive Board member Juergen Stark noted the materialization of “second-round” inflation effects from energy and food prices, saying that wages were rising at “annual rates not seen since the mid-1990s.” The ECB has frequently cited a need to maintain price stability so as to avoid these “second-round effects,” and as a result, it is clear that the central bank will not even consider cutting rates anytime soon. While Credit Suisse overnight index swaps may be pricing in over 25bps worth of cuts within the next 12 months, I do not expect the ECB to do so until Q4 2008 or early 2009. Furthermore, like the British pound, the euro remains extremely oversold and there are indications that EUR/USD could advance.

Australian Dollar, New Zealand Dollar Surge on Demand For Yield

The Australian dollar and New Zealand dollar both surged on Monday thanks to a new-found demand for risky, high-yielding assets. While the Reserve Bank of Australia and Reserve Bank of New Zealand are both expected to cut rates by at least 100bps over the next 12 months, the central banks still hold some of the highest benchmarks in the G10 (RBA: 7.00 percent, RBNZ: 8:00 percent). However, commodity prices – which hold a strong correlation with the Aussie – ended the day very little changed. Traders shouldn’t brush off that correlation though. If the market’s attention turns away from Fannie Mae/Freddie Mac and back to commodities, oil and gold could become the big driver of the commodity dollars once again. Meanwhile, event risk will pick up significantly for the comm bloc this week. The biggest by far will be the Reserve Bank of New Zealand’s rate decision, since they are expected to cut rates for the second consecutive month by 25bps to 7.75 percent, according to 13 of the 14 economists polled by Bloomberg News. It is telling, though, that the last economist actually anticipates a 50bps cut. The key to the New Zealand dollar’s reaction, though, will be RBNZ Governor Bollard’s post-meeting commentary. Credit Suisse overnight index swaps are already pricing in nearly 150bps worth of rate cuts within the next 12 months, but if Mr. Bollard mimics his dovish policy statement from July, this sentiment will be exacerbated and the New Zealand dollar will likely plunge. Meanwhile, New Zealand retail sales, Australian retail sales, and the Australian net employment change are all likely to be negative fundamental factors for Kiwi and Aussie.

Terri Belkas is a Currency Strategist at FXCM.