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It's Rate Cutting Time
Last week, we saw the Bank of England reduce its benchmark interest rate from 5.75% to 5.50%, and the Bank of Canada also reduced rates, from 4.50% to 4.25%. Suddenly, these two currencies aren't looking as bullish vs. the U.S. Dollar, at least for now. The Fed has its say on December 11, with most analysts calling for a quarter point rate cut, but some expecting a half-point reduction in rates from the current 4.50%.
After announcing its first interest rate cut in two years, the Bank of England (BoE) issued a statement saying that growth had begun to slow, citing tight credit conditions and a weak housing market. The huge red candle near the right of the chart, representing a plunge of over 300 pips, was initiated by weak housing number, and the BoE cut interest rates the next day. Expect to see further rate cuts from the BoE next year, leading to further weakness in the Pound. Some traders have suggested that the GBP/USD pair has the look of a very sloppy head and shoulders formation (see figure 1).
Figure 1: GBP/USD plunges to support prior to an interest rate cut. Source: Saxo Bank
Meanwhile, a very different story is shaping up north of the U.S. border. Earlier in the week, the Bank of Canada caught the markets by surprise with its own rate reduction, citing the strong Canadian Dollar as a factor leading to a decline in exports. In fact, the country's trade surplus narrowed to a nine-year low of C$2.7 billion in September, according to Statistics Canada. With the Fed cutting rates to avert a slowdown in the U.S. economy, Canadian exporters may be worried, as about 85% of Canada's exports are destined for the U.S.
Will Canada continue to cut interest rates? Friday's Canadian employment figures showed tremendous strength, so the BoC may have limited room for maneuverability. Canadian employers hired a net 42,600 workers in November, crushing analyst estimates of 8000. With a booming economy and concerns about inflation, Canada's central bank may cut rates just once more to 4.00%. This could mean an end to the recent rally in USD/CAD, and a resumption of the long-term downtrend, seen here on the weekly chart (see figure 2).
Figure 2: USD/CAD's five-week bounce may be coming to an end. Source: Saxo Bank
Not every central bank presented with an opportunity to cut rates last week did so. The European Central Bank (ECB), fighting annual inflation of over 3%, held firm at 4.00%, and the Reserve Bank of Australia (RBA) held the line at 6.75%, citing renewed volatility in the global financial markets. Some analysts thought that Australia's strong growth – GDP is skyrocketing at a 4.3% annual rate - would force the RBA to raise rates to 7.00%. AUD/USD also looks suspiciously toppy, another currency pair with a technically incorrect but hard to ignore head and shoulders formation (see figure 3).
Figure 3: AUD/USD is fundamentally sound but technically sloppy. Source: Saxo Bank
Here Comes The Fed
So what action will the Federal Reserve take at the December 11 FOMC meeting? If you saw my appearances on CNBC or Fox last week, you already know that I believe we'll see an unusual mix – I expect a quarter point reduction in the Fed funds rate, and a 50 basis point reduction in the discount rate. Here's why – banks are once again becoming reluctant to lend to one another. The last time this was an acute problem was in August, and Ben Bernanke and the Fed responded by reducing the discount rate, which is the cost of borrowing funds directly from the Fed. This action seemed to solve the problem, at least temporarily. Banks are reluctant to borrow from the Fed, mainly for two reasons; first, the so-called Discount Rate offered by the Fed is higher than the Fed Funds Target rate, and secondly because there is a stigma attached to borrowing directly from the Fed. Why would a bank borrow directly from the Fed at a higher rate, unless that bank is having difficulty getting a loan from other banks?
The discount rate is currently 50 basis points higher than the Fed funds rate. If the Fed lowers the discount rate at a faster pace than the Fed funds rate, it will lessen the differential in borrowing costs to the banks, and thus remove some of the stigma attached to borrowing directly from the Fed. The current weekly average of funds borrowed directly from the Fed is $342 million, but the draw on Dec. 5, at $2.15 billion, was the highest since mid-September. One influential Fed official, Federal Reserve Bank of San Francisco President Janet Yellen, telegraphed a potential sharp cut in the discount rate when she spoke on December 3rd. Yellen said the so-called discount window for direct loans "has not been as used, or been as helpful at addressing liquidity issues, as I would have hoped". By expressing her dissatisfaction, I think she's trying to tell us that the discount rate will fall more quickly than the Fed funds rate. We'll find out on Tuesday.
Millionaire's Club
China's roaring economy has been accompanied by an explosion in the number of very wealthy people in that country. China now has 106 billionaires, up from just 15 a year ago, according to Shanghai-based Hurun Magazine. China had 345,000 millionaires by the end of last year, the second-most in Asia after Japan, according to investment bank Merrill Lynch. The number of millionaire households increased the most last year in China (up 39%), Spain (up 32%), and Britain (up 30.5%). Which country boasts the most millionaires? It is by far the United States at 4.6 million, up 10% last year.
This weekend, China ordered banks to increase reserves, forcing lenders to put aside 14.5% of deposits, up from 13.5%. This was the largest of the ten reserve increases ordered this year, and is designed to remove about 380 billion Yuan ($51 billion USD) from the banking system. It's ironic that China is attempting to remove liquidity at the same time that most central banks are adding liquidity. China's surging exports are pumping cash into its financial system, fueling inflation and concerns that its economy will overheat. This week, U.S. Treasury Secretary Henry Paulson visits Beijing, so look for some additional Yuan appreciation vs. the greenback.
A Glimpse of the Future
It seems that some of the world's most prestigious financial institutions are selling themselves piece by piece in order to make restitution for their subprime sins. Cash rich countries are bailing out these giants, and in return are walking away with substantial chunks of some of the world's best-known brands. Last month, Abu Dhabi injected $7.5 billion USD into Citigroup after losses on mortgage products crushed that company's stock. In return, Abu Dhabi received a 4.9% stake in the U.S. financial services monolith. Now UBS, facing a $10 billion USD write-down over mortgage-backed securities, is receiving $11.5 billion, mostly from Singapore, which in return will walk away with a 9% stake in the Swiss banking giant. What is next for the so-called sovereign wealth funds? Brazil is creating a fund that is geared not toward buying pieces of companies, but will buy U.S. Dollars instead. The plan is to sell the Brazilian Real and buy the USD, in order to keep the Real from appreciating too quickly vs. the greenback. The roaring Real has outperformed most currencies in 2007, gaining 21.5% vs. the U.S. Dollar this year.
I Love New York! Pop quiz – which Online Trading Academy location was voted Franchise of the Year for 2007? Why, New York of course! John Bang, Tony Michaels, and the whole gang at Online Trading Academy New York would like to invite you to attend a free seminar and book-signing event with me on Wednesday January 9, 2008. Hey, what else would you expect from the Online Trading Academy's Franchise of the Year? Mark your calendars and don't miss this event - I can't wait to see all of my friends in the New York area!
Have a question about Forex trading? Send an email to eponsi@tradingacademy.com and we may use your question in an upcoming newsletter. Until next time, best of luck to you in trading.
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Ed Ponsi is a globally recognized name as a lecturer and teacher and is the former Chief Trading Instructor for Forex Capital Markets. An experienced professional trader and money manager, Ed has advised hedge funds, institutional traders, and individuals of all levels of skill and experience. Ed has appeared on CNBC, CNN International and TheStreet.com, and has recently written his first book for Wiley Finance, "Forex Patterns and Probabilities" (which you can purchase through