Quarter End Flows Drives US Dollar Higher

TODAY'S BIGGEST PERCENTAGE MOVERS

• USD/CHF (+500 pips or +2.75%)
• EUR/NZD (-500 pips or -2.33%)
• NZD/JPY (+156 pips or +2.23%)

THE STORIES IN THE CURRENCY MARKET

• USD: QUARTER END FLOWS DRIVES US DOLLAR HIGHER
• EUR: EURO DROPS 4 BIG FIGURES ON MORE BANK BAILOUTS
• GBP: BRITISH POUND BREAKS BELOW 1.80
• JPY: STOCK MARKET RALLY TAKES YEN CROSSES HIGHER
• CAD: GDP RISES 0.7%
• AUD: GOLD PRICES FALL TO $871
• NZD: BUSINESS CONFIDENCE IMPROVES

EXPECTATIONS FOR UPCOMING FED MEETINGS

** PERCENTAGES MAY NOT ADD UP TO 100% BECAUSE OF THE PROBABILITY OF LARGER OR SMALLER MOVES BEYOND THOSE SHOWN ON THIS TABLE

QUARTER END FLOWS DRIVES US DOLLAR HIGHER

It is the end of the third quarter and demand for US dollars has been exceptionally strong. This is related to repatriation flows and profit taking following yesterday's big moves. The stock market closed up 485 points, which is approximately 60 percent of Monday's historic sell-off. On the bailout front, since Congress is on recess for the Jewish holidays, there have been no significant developments. As a result, to credit today's rally on the hope for a new bailout plan may be a bit of a stretch since the Senators haven't even sat down to discuss potential changes. Therefore we still believe that yesterday's sell-off is the market's true sentiment towards the US dollar and US stocks and so far, there aren't any concrete reasons to believe otherwise.

How Higher LIBOR Rates Impact Average Americans

Despite today's recovery, there is evidence that investors and banks are still nervous. The overnight LIBOR rate which is the rate at which banks lend to each other hit an all-time high of 6.88 percent intraday. The 3 month LIBOR rate is also above 4 percent, the highest level since January. For the average American, overnight lending rates or the 3 month LIBOR have little significance until they realize that many home equity loans, lines of credit, student loans, small business loans and credit card rates uses LIBOR as an index. Therefore the rise in borrowing costs will surely be felt on Main Street as lenders charge higher interest rates on loans. For the average American, this adds further strain to their ever-thinning pocketbooks. Lending between banks is frozen as counterparty risk remains the number one problem in the financial markets. Volatility continues to remain high and we do not see any reason for that to change either. Yesterday, the S&P500 fell by the largest amount in 20 years and today, the index came close to rising by the most in 6 years. This schizophrenic behavior of the markets is sure to turn many investors gun shy.

Will An Interest Rate Cut Help?

In order to restore confidence at this stage of the game, the Bush Administration needs to shock the markets. One way of doing so could be through a rate cut by the Federal Reserve. As one of the most powerful psychological tools in the government's arsenal, Bernanke may want to save it until there is evidence that the new bailout plan has failed to stabilize the markets. Fed fund futures have already priced in a quarter point rate cut between now and the October 29 monetary policy meeting. However the futures contracts have been wrong in the past and should the new bailout package prove to be stronger than the one proposed on Monday, the futures contracts will price in a smaller chance of a rate cut. For the Federal Reserve, after pumping a huge amount of liquidity into the financial system, inflation has become a very big concern. Therefore Bernanke will not readily agree to cut interest rates unless he has no other choice. Furthermore, a measly 25bp rate cut from the Fed may not do the trick. Risk aversion is so severe that the only things that can stabilize the markets may be a 50bp one shot rate cut or a coordinated easing by central banks around the world, but Bernanke will have a tough time convincing his Eurozone counterpart, Trichet.

Raising the FDIC Limit

In the latest development of the bailout drama, the most popular and likely proposal is to raise the FDIC insurance from $100,000 to $250,000. This bribe to Main Street offers a jolt of confidence and a peace of mind. For the government no initial outlay is needed to increase the FDIC limit. The 3 big banks that are left on Wall Street - Bank of America, J.P. Morgan Chase and Citigroup will still be here when the dust settles. According to today's WSJ, the Big 3 holds approximately 75 percent of all US deposits. Therefore even if other commercial banks fail, the FDIC only has to fork up a limited amount of money and even if they have to fork up more than that, it is the confidence booster that Americans need.

Consumer Confidence Improves but Still Near 16 Year Lows

Interestingly enough, despite the problems in the US financial markets, consumer confidence actually improved in the month of September. However the index still remains near its 16 year lows and is half of what it was a year ago. It is important to note that the survey was closed on September 23, which was before the 777 point slide in the Dow. The Chicago PMI index also beat expectations even though manufacturing activity in the Chicago region slowed this month. There were no silver linings in the house price report, which dropped 16.3 percent in the month of July, the fastest pace on record. On Wednesday we are expecting our first leading indicators for Friday's non-farm payrolls. This includes the ADP employment change, the Challenger layoffs report, and manufacturing ISM. The numbers will shed more light on the weakness of the US labor market.

EURO DROPS 4 BIG FIGURES ON MORE BANK BAILOUTS

The Euro dropped 4 big figures or 400 pips on an intraday basis. This is the single biggest one day decline for the EUR/USD since its inception in 1999 and was driven concern for European banks. This morning, France and Belgium bailed out Dexia SA, which is the world's biggest lender to local governments. This follows the 11 billion Euro bailout of Fortis this weekend, Belgium's largest financial services company. In yesterday's Daily Currency Focus, we said that based upon the amount of bank failures in the US, there is a strong chance that Fortis would not be the last bank bailout in Europe. The failures of one bank can easily spillover to another, which is why investors are worried that this could be a slippery slope. As for economic data, we are seeing more weakness. Inflation seems to be easing while the labor market in Germany remains weak. The latest bank failures in Europe have led many economists to revise their ECB rate calls. JPMorgan and Goldman Sachs now expect the European Central Bank to cut interest rates by 25bp before the end of the year. German retail sales are due for release Wednesday morning.

BRITISH POUND BREAKS BELOW 1.80

Broad dollar strength drove the British pound below 1.80 to a low of 1.7759 today. Economic data was slightly weaker than expected with the current account deficit rising from GBP8.4 billion to GBP11.0 billion. This is the largest deficit for the UK in close to a year and reflects the difficulties that the UK economy faces. Second quarter GDP remained unchanged at 0 percent. We continue to believe that the UK economy is at risk of falling into a recession and the latest bank failure in the UK is not going to help. Manufacturing ISM is due for release tomorrow. There is a strong chance that we will see a further contraction in the manufacturing index. The market is looking for the Bank of England to cut interest rates by more than 100bp over the next 12 months,

STOCK MARKET RALLY TAKES YEN CROSSES HIGHER

With the strong correlation between the US stock market and USD/JPY, it is not surprising to see nearly all of the Yen crosses rally on today's 485 point rally. In Monday's Daily Currency Focus, we listed EUR/JPY as the currency pair in play and even though German unemployment numbers were not exceedingly weak, the currency pair fell into the sell zone, like we had expected. This is an example of how combining technical and fundamental analysis can give traders an increased edge. If the fundamentals are right, it will help to push the trade in the desired direction and if it is wrong, sentiment and technicals could also help the trade. The Quarterly Tankan report is due for release this evening, expect business confidence to deteriorate.

STRONGER DATA FAILS TO HELP THE COMMODITY CURRENCIES

The Australian and Canadian dollars weakened against the greenback despite stronger economic data. In Australia, retail sales rose 0.3 percent in the month of August thanks to greater spending on food, clothing and restaurants. Canadian GDP rose by 0.7 percent on rising oil prices. Dollar strength is the main driver and the reason why the AUD and CAD have failed to rally. The one currency that did gain strength against the greenback was the New Zealand dollar. Business confidence improved materially, suggesting that the Reserve Bank's interest rate cuts may be working. Service sector PMI is due for release from Australia – activity is expected to remain in contractionary levels.

EUR/USD: CURRENCY PAIR IN PLAY OVER THE NEXT 24 HOURS

German retail sales are due for release at 2:00am ET or 7:00 GMT while the US ADP employment report is due for release at 8:15am ET (12:15 GMT) followed by manufacturing ISM at 10:00am ET or 14:00 GMT. The EUR/USD will be the currency pair in play over the next 24 hours on the combination of key Eurozone and US data.

Technically, the EUR/USD is in the "range trading zone," which we determine using Bollinger Bands. However it is at the brink of entering our "sell-zone." This is a similar setup as the EUR/JPY on Monday. Should we get some weak German economic data, we could see EUR/USD fall into the sell zone which would happen on another break of 1.4100. At that point, we could see selling exacerbate as support does not come in until 1.40. However should the data be good or the Euro. Then we will be looking at a move above 1.42 which would open the door for a move to the key Fibonacci resistance at 1.4400

Kathy Lien
http://www.gftforex.com

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