More Interest Rate Cuts for the UK as deflation takes hold

Pound Sterling Outlook : The deflation scare is upon us, perhaps a little ahead of schedule. The UK reported that Oct CPI fell 0.7% m/m to an annualized 4.5%--from 5.2% in September. The retail price index (includes mortgage costs) also fell from 5% annualized to 4.2%. A RBC Capital currency analyst quoted in the FT says inflation has turned the corner and is now so accerlated that the UK risks CPI under 1% by the second half of next year. “With the risk of outright deflation therefore on the rise, we continue to see further imminent aggressive rate reductions on the part of the BoE. Our base case remains that of four back-to-back 50 bp cuts with rates falling to 1.0% by the end of the first quarter of 2009.” And a bigger cut at the Dec 4 meeting is still a possibility, too.

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Barbara Rockefeller
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Stark saying things are worse than we think in Europe

Pound Sterling is fascinating these days, first rising yesterday morning from 1.5598 at midnight to 1.6097 around noon, or 499 points in 12 hours - but then falling back to 1.5747 in the next 12 hours, only to bounce to 1.6047 again so far today.

What is causing these wild currency swings?

The reason seems to be that really bad data releases (see below) are inspiring forecasts of bigger-than-expected rate cuts tomorrow, maybe as much as 100 bp.

These days a big fat interest rate cut is currency-supportive (see Australian Dollar). Well, with Stark saying things are worse than we think in Europe, why isn’t the euro exchange rate getting the same boost? Possibly because nobody thinks the ECB would do anything as outrageous as surprise the market with a European interest rate cut of more than 50 bp tomorrow, and maybe not even that.

Maybe if the ECB cuts interest rates by 1pc we may see Spanish and French banks willing to issue spanish and french mortgages

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Barbara Rockefeller
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ECB expected to cut interest rates tomorrow

Foreign Exchange Technical Analyst Outlook : The move in the Canadian dollar is starting to look like a reversal move, even though we don’t have a moving average crossover (which lags). Momentum, breaking the old low and other indications all point to a foray to the channel bottom, if not beyond. The upmove in the Australian Dollar is similarly strong. Remember, for reasons nobody understands, the Australian Dollar often leads the euro so soon you can see foreign exchange traders buy euros. If we were to superimpose a chart of oil and/or the commodity index on the Australian Dollar, we’d probably see a pretty good apparent correlation.

On the euros to dollars chart, we are going to fall back on the old adage that it’s still a downtrend until a key level is taken out. We judge that to be 1.3102, the midpoint of the breakout bar on 10/30, and the highest high in the current swing, 1.3298. With the ECB expected to cut interest rates tomorrow, this seems unlikely unless the market perversely rewards the ECB for doing the right thing economically. The probability is not zero - see the Australian Dollar again. We also have a really bad US payrolls number due on Friday.

Is it already priced in?

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Barbara Rockefeller
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Bank of England to cut interest rates by 1 percent?

Pound Outlook : Ahead of the Bank of England action tomorrow, UK data continues to disappoint. Factory production fell 0.8% m/m in Sept for the biggest drop in 19 months. Output has fallen for 7 months for the longest losing streak since Thatcher (1980). Factory production is down 2.3% y/y. On the quarterly basis, output fell 1.3 q/q, the biggest drop since Q2 2001, which came right after 9/11.

In addition, the CIPS index of services fell from 46 in Sept to 42 in Oct, the lowest ever. The employment sub-index fell to the lowest since the survey began, according to Bloomberg. “Expectations” also fell to a record low, 50.8 from 58.2 in Sept. Some foreign exchange analysts say these terrible numbers will prompt a rate cut of more than 50 bp.

Pounds to Euros currently 1.2346
Pounds to Dollars currently 1.6180
Pounds to Australian Dollars currently 2.3288

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Barbara Rockefeller
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The US dollar put in some solid gains yesterday during the US session, reversing an early rise in the euro exchange rate

Euro Exchange Rate Outlook :

The US dollar put in some solid gains yesterday during the US session, reversing an early rise in the euro exchange rate to 1.2893 to a low of 1.2572 by 6 pm. Market News says the market was exceptionally thin. But in Asia and Europe so far today, the euro rate is coming back up off the low to retrace about 75% of yesterday’s drop and we are suddenly newly wary of breaking yesterday’s high.

While we always have to be ready for a big countertrend moves, this one comes out of left field and we can’t find a decent explanation. Market News and Bloomberg both suggest that falling interest rate spreads and rising equity markets in Europe for the 6th day are a cause for acceptance of risk. But only yesterday the European Commission confirmed a diagnosis of recession. The ECB is expected to cut euro mortgage rates on Thursday. The US election will likely return a dollar exchange rate friendly Obama, although the prospect of a disputed vote may be causing harm, however small the probability of that outcome. To buy euros on rising stock markets seems a frivolous thing, doesn’t it? Calling it a "perception of risk reduction" is just putting semantic lipstick on what is still a pig.

The dollar to japanese yen is breaking yesterday’s high of 99.64 but only by a little. It’s a minor move up off the low late last night at 98.48, and barely worth mentioning except this is also the high from last week, and a higher high is always notable, even if the move lacks momentum. Many observers forecast a rise to the high before that at 103, and that would be a true breakout. Remember, a drop in risk aversion and embrace of risk is the only reason to believe in this scenario, and therefore a big new risk Event could reverse it in minutes. We say the market for yen crosses is not acknowledging the depth of the economic trouble to come.

The NKS has a story today on demand for "cheap euros" from Japanese retail investors. This accounts for a very big amount, unlike in the US. “The European common currency traded above 160 yen until late August, but it slumped to the 113 yen range on Oct. 24, when a deepening financial crisis in the eurozone sparked panic selling. The sharp fall prompted many Japanese individuals to buy euros for yen. Some were planning to make a trip to Europe in the near future, but many others were looking to lock in forex gains, apparently in the belief that the euro will recover its value against the Japanese yen sooner than later. Some of these investors formed a long line at a foreign-exchange corner of a major bank here last week. Demand for the euro was so strong that the currency remained in short supply at the branch throughout the week." The writer of the article disapprovingly adds, "In any event, the fact that many Japanese are opting to hold their assets in cash, albeit in foreign currency, appears to demonstrate a serius loss of investor confidence resulting from the ongoing financial crisis."

Pounds to Euros currently 1.2300

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Barbara Rockefeller
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Euro Exchange Rate : The European Commission said growth will slump to 0.1% next year

Euro Exchange Rate : The European Commission said growth will slump to 0.1% next year, having entered recession this year. It’s the worst growth picture since 1993. GDP will contract for three consecutive quarters this year for a full-year total of 1.2%, European finmins are meeting today in Brussels to try to figure out what to do. Bloomberg notes that “While France and Germany led European governments in committing a combined $1.7 trillion to protect the region's banks, and the European Central Bank now offers unlimited loans in an attempt to get credit moving, there has been no unified government response.”

EU Commissioner Almunia said the EU needs better coordination in some areas. The situation is "precarious" as demand from emerging markets is easing (goodbye., exports), although inflation pressure is also easing. The euro exchange rate is closer to fundamentals and the eurozone economy will reach bottom in mid-2009. Seven members will reach deficits breaking Maastricht/Stability Pact with deficits over 3% in 2009. In fact, the Commission will start the "excessive deficit procedure" against Ireland. Oh, and the EU will not allow any new members in until after spring 2010 - they might want some money.

In hard data, the eurozone October manufacturing PMI fell to 41.1 from 41.3 in the flash estimate and 45 in Sept, the lowest ever. In Germany, the October manufacturing PMI fell to 42.9 from 43.3 in the flash and 47.4 in Sept. It was worse in France--40.6 compared to 43 in Sept. Italy had the worst manufacturing PMI ever at 39.7, from 44.4 in Sept. A number under 50 means contraction.

Best Euro rate to buy euros currently 1.2400

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Barbara Rockefeller
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In fact, the weak pound has already delivered the equivalent of a rate cut.

Pound Outlook : head of the expected Bank of England interest rate cut this Thursday, the FT has a really interesting story on UK companies actually benefiting from the drop in the pound. If the Bank of England were to cut by more than the built-in 50 bp, it would boost stocks because of a currency effect. In fact, the weak pound has already delivered the equivalent of a rate cut. “A rough yardstick suggests that every 10 per cent fall in the pound against the US dollar exchange rate equates to 25 basis points in monetary easing due to the beneficial effect on exporters and the pressure it takes off domestic manufacturers at home.”

An astounding 41% of the FTSE 100 (market cap) report earnings in dollars, incuding oil companies, minign companies, banks and some pharmaceuticals. “Calculating an Foreign exchange related rule of thumb for earnings is tricky, given the lack of information about the denomination of companies’ cost bases and financing requirements. However, for dividends it is much more straightforward: every 10 per cent fall in the value of the pound to dollars adds nearly 4 per cent to UK dividend growth, all other things being equal. “

On the other hands, “JPMorgan estimates that adverse foreign exchange movements have pushed annual UK retail inflation up from 7.7 per cent in June to 10.5 per cent. Retailers may try to pass on these increases to maintain margins. However there is every chance that, in a deflationary world, consumers will respond by trading down or buying less. This puts retailers such as Next in the firing line due to the comparatively high prices they charge. However, on balance, sterling’s weakness should be a boon for UK stocks, albeit a limited one given the air of gloom surrounding global asset markets.”

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Barbara Rockefeller
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Buying Euros, Pounds to euros at best euro rates - Contact IMS Foreign Exchange