By DailyFX – Federal Reserve Sends 3 Messages to the Markets: Countdown to Easing Begins. It has been a busy… … week in the financial markets with two to three hundred point intraday swings in Carry Trades and the Dow quickly becoming the norm.

Both the US stock market and carry trades took a
beating this week. The US dollar on the other completely reversed its
downtrend and came close to erasing all of its year to date losses
against some of the majors. Central banks have pumped over $350 billion
in liquidity into the markets with limited success, forcing the Federal
Reserve to lower the discount rate from 6.25 to 5.75 percent this
morning in addition to injecting more liquidity into the financial
system.Along with the cut, they issued a statement that was far more dovish
than the one released at the August 7 FOMC meeting. This sent three
messages to the market. The first is that the liquidity injections have
not been enough. The second is that the subprime, credit and liquidity
debacle is indeed hitting the real economy and the third is that they
have officially dropped their hawkish bias which means their next move
will be to cut interest rates. Cutting the discount rate is different
from cutting the Fed Funds target rate , but by doing so, the chance for a September rate
cut has multiplied significantly. The interest curve is now pricing in
75 basis points of easing by the end of the year. In response to the
discount rate cut, the dollar has given back its gains, carry trades
have reboundedand the Dow ended the day in positive territory. The next
monetary policy meeting is not until September 18th which will be the
markets main focus over the next few weeks. There are 3 possible
scenarios. The first is for the Fed to cut the Fed Funds target rate by
25bp in Sept and Oct. The second is to cut by 50bp in Sept and the
third is to delay an interest rate cut until Oct. The first scenario is
the most likely one, but the second and third will be the bigger market
movers. Unsurprisingly, the University of Michigan survey of consumer
sentiment dropped to the lowest level in a year. We expect consumer
confidence and consumer spending to continue to be weak as mortgage
payments begin to rise, companies begin to slow hiring and homeowners
are pushed into foreclosure. In the week ahead, handicapping what the
Federal Reserve will do in September will continue to be the predominant
driver of market fluctuations. The economic calendar is relatively
light with only leading indicators, durable goods and new home sales due
for release.

Will the ECB Still Cancel its Plans to Raise Rates in September?

The Federal Reserves reduction in the discount rate today raises the
question of whether the European Central Bank will follow through with
raising interest rates next month. The probability of an ECB rate cut
has dropped from 90 percent two weeks ago to 25 percent today. Many
banks have shifted their outlook and are now not calling for a September
rate increase. Today, ECB member Weber said that the central bank will
do all that they can to ensure price stability and when asked whether
the central bank still plans on raising interest rates or use strong
vigilance on price risks, he declined to comment. This definitely
suggests that the central bank could cancel its plans to raise rates
next month. Economic data is showing signs of slowing alongside
inflation. This mornings German producer price data reflected a 0.1
percent monthly drop in July. ECB President Trichet has not shown any
signs that he too is reconsidering the central banks earlier plans to
cut rates. We will be watching his commentary closely in the next few
weeks. Meanwhile, even though the German ZEW report is due for release
next week along with GDP and Eurozone PMI, the data should take a
backseat to the movements in the equity and bond markets. Switzerland
also has a lot of data due for release including producer prices, trade
balance and employment. Not many people have talked about whether the
Swiss National Bank will still raise rates. At this point, we think
that the chances are low.

Reserve Bank of Australia Intervenes for the First Time in 6 Years

The Reserve Bank of Australia is desperately trying to prop up its
currency. From its July 25 high, the Australian dollar has fallen as
much 13 percent against the US dollar and 20 percent against the
Japanese Yen. The currencys losses over the past week are steepest in
24 years and far surpass the biggest weekly loss in October 1998. Even
though the Australian dollar reversed quite a bit today, the initial
reaction off of the RBA intervention was minimal. In fact, the
Australian dollar went on to hit a new 9 month low in early European
trading. With only $64.87 billion in foreign exchange reserves, the
central bank has little to work with. However, their intervention
indicates that they have shut the door on further interest rate hikes.
The New Zealand dollar moved in lockstep with the Australian dollar
while the Canadian dollar reversed significantly after the Feds
discount rate cut. There is a lot of data on the Canadian calendar next
week, so expect the currency to be in play. There is no Australian data
but New Zealand will be releasing their trade balance.

Volatility Rocks the British Pound

The British pound has been extremely volatile this week due to active
trading in the GBP/JPY which has moved up and down a hundred pips within
a blink of an eye. It has been an exceptionally tough week for the
British pound, which has lost approximately 400 pips against the dollar
and more than 1000 pips against the Japanese Yen. Hopefully that will
change with the heavy UK calendar next week. The Bank of England is one
of the few central banks sitting on their hands throughout the credit
market and liquidity debacle.

Japanese Yen Crosses Reverse Course after Fed Announcement

The Japanese Yen Crosses recovered most of their earlier losses after
the Federal Reserve lowered the discount rate. At one point, all of the
crosses were in the green for the day when the Dow opened up over 300
points. The Nikkei took a heavy beating last night with the index down
5.4 percent, which was the largest drop in 7 years. The announcement by
the Fed today should help to stabilize some of the Asian markets. At
this point, there is zero chance that the Bank of Japan will be raising
interest rates next week.

DailyFX Research Team
Forex Capital Markets LLC
32 Old Slip, 10th Floor
New York, NY 10004
Tel (212) 897-7660
Fax (212) 897-7669
E-mail: research@dailyfx.com

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