Gain Capital

What a week, to say the least. Equity markets plunged across the globe as investors panicked in the face of reduced credit availability, which accelerated de-leveraging and the unwinding of higher-risk positions. (De-leveraging refers to scaling down the size of position to a lower percentage of assets under management. In short, it means positions are sold sizes across all asset classes.) In the currency market, JPY-crosses (EUR/JPY, AUD/JPY, GBP/JPY, NZD/JPY) fell out of bed as carry trades continued to be unwound.

In last week’s update, I suggested that a sharp downside breakout in the JPY-crosses was looming, and this week’s price action certainly confirmed that view. The USD also benefitted against non-JPY currencies, as a combination of JPY-cross selling and unwinding of short-USD bets weighed on the non-JPY USD-pairs.

But lo and behold, the Fed surprised markets with a 50 bp discount rate cut early Friday morning, generating a late-week recovery in global equities. Significantly, though, this was not accompanied by a similar rebound in the JPY-crosses, suggesting that further unwinding (selling JPY-crosses) is left to be done. JPY-crosses are set to close the week sharply lower, but also well above their intra-week lows.

What does the Fed discount rate cut mean and what doesn’t it mean? The Fed cut the discount rate 1/2% in an effort to stabilize financial markets and prevent a spillover into the larger economy. The discount rate is the rate at which the Fed lends directly to banks that are unable to access funds in the inter-bank lending market, so it’s the lending vehicle of last resort. Banks that borrow at the discount window are normally seen to be in serious trouble, so banks are extremely reluctant to access funds in that way, and the reduced discount rate of 5.75% is 1/2% above Fed funds rate, so it's still a penalty rate.

Many in the market are taking this as a sign that the Fed is going to cut the Fed funds rate and hence the relief rally in stocks and some other risky assets. I would suggest that it is not yet clear that the Fed is intent on cutting Fed funds just yet. The discount rate cut could be seen simply as another sign of assurance to the market that the Fed will continue to provide needed liquidity, but that the Fed's overall monetary policy stance remains largely unchanged, pending evolving economic data.

But even if we assume that this is a precursor to a Fed funds rate cut, what does it mean for the USD and other currencies? The dollar initially weakened against other major currencies, but has since stabilized, reflecting the increased likelihood that interest rates in other major economies will be cut or not raised, as previously expected. Rate hike expectations for the BOE and ECB, for example, are being scaled back at this writing. The net effect is the same--expectations of interest rate differentials are roughly unchanged, so there does not seem to be a direct USD-negative result here.

In terms of the larger market outlook, increased risk aversion of late based on a withdrawal of credit and lingering doubts in the debt market seems unlikely to dissipate just on the basis of a lower symbolic interest rate. It's not like the Fed can wave a magic wand and erase the fear and volatility of markets as though it never happened. Credit has been reduced and the market has been forced to de-leverage--cutting positions across all markets and registering heavy losses in the process.

Lower interest rates are not sufficient on their own to trigger a return to the easy money days of recent years. There has been a systemic shift to a reduced risk appetite and it will take many months until investors feel emboldened enough to jump back in. In the meantime, de-leveraging continues and more bad news is likely to emerge in the days and weeks ahead.

Looking at the big-picture charts, the signals are mixed, with the only obvious conclusion being that higher volatility is likely to remain persistent. US equity markets (S&P) are posting a ‘hammer’ on the weekly charts, which is a bullish reversal signal after a move lower. European equities (Stoxx 50), however, are posting a more neutral ‘long-legged doji’ on a weekly basis, which leaves the door open to uncertainty, which in the current environment I equate with downside risks. The USD dollar index is posting an upweek, but was soundly rejected from major weekly trendline resistance dating back to October 2006 at 82.25. On the downside for the USD, daily support in the USD’s recovery from the double bottom at 80.00 comes in at 81.00/05, which was the post-Fed discount rate cut low. That level equates to roughly 1.3550 EUR/USD. While that level remains intact, I look for the USD to continue to improve against EUR, GBP, AUD, and NZD; should it fail, the USD is coming under renewed pressure.
USD/JPY has seen extraordinary, but not unprecedented, volatility and it seems highly likely that it will continue. Price action has been extremely fast as inter-bank spreads have widened out and liquidity is at a premium. Overall, I look for USD/JPY to stabilize between 112-115 for the next week. Gains over 115.50 are likely to spark short-covering, but I think we would need to get back above 116.50/75 to end the downside rout. Below 111.50 and it looks like we are heading for the 109.75/110.00 major support level, below which its light’s out. I remain a seller on rallies of the JPY-crosses, with 155.00-156.50 the ideal sell zone in EUR/JPY.

Turning to the data for next week, it will likely remain secondary to overall market price developments, with negative reports or surprises weighing more heavily on the local currency than upbeat reports will provide support.

US data is mostly light next week and begins with the Conference Board’s July leading indicators due on Monday morning. Tuesday sees weekly ABC consumer confidence after the close. Wednesday has only weekly MBA mortgage application data. Thursday sees weekly jobless claims. Friday finishes up with July durable goods orders and July new home sales. The only scheduled Fed speaker is Richmond Fed president Lacker (hawkish, non-voter) who will be speaking on risk management.