How much will the ECB and BOE cut? How much does the market care? Larger than expected cut could actually be bullish for EUR.

Thursday, November 6, 2008

The ECB and BOE are on tap today. While some have talked up the idea that the ECB could cut by more than 50 bps, we suspect that the bank will only move by 50 basis points at a time since its last cut came less than a month ago and the bank has tended to drag its heels relative to market expectations, to put it mildly. We can certainly expect dovish guidance. The bigger question is the size of the BOE cut today, with the market seemingly leaning more and more towards a 100 bp cut, even if 50 bps is still the official consensus. Perhaps they will go 75 in a RBA copycat move? Anything over 50 bps from the ECB could actually trigger a sharp rally in EUR, as investors are more worried about measures to shore up the economy than interest rate differentials at this point. Same goes for BOE, though higher odds of a larger cut are priced in there.

The very biggest question going into the two central bank meetings today is how much the market cares at this point and how much the entire situation is simply a function of the general risk appetite picture. We lean mostly on this last statement. With bonds flying high again and the sharp pre-election rally sharply reversed, it looks like we have the ingredients for a continued move back to risk aversion in the near term. The aggressive way to play this is in the JPY crosses - particularly EURJPY and GBPJPY, while those with more frail nerves may look for a slower mover (still plenty of volatility!) like EURCHF. If equities turn around again, however, we will be looking at a possible extension of the countertrend rally.

The US ISM Non-manufacturing data point yesterday was very bad as we expected, posting the lowest level in the 11-year history of the survey. This is an especially negative sign for the economy as it represents a far broader swath of the US economy than the manufacturing index. The employment component of the index was also sharply lower from September levels at 41.5. To add to the bleak employment picture, the US ADP employment number yesterday was weak, too, as was the Challenger Job cut survey. This will in all likelihood lead to a very ugly US employment report tomorrow - more on that with tomorrow's report.

Miraculously, the Australian employment numbers overnight were much stronger than expected, with the unemployment rate unchanged and the payrolls expanding sharply vs. the expected small contraction. This will not continue as employment is a lagging indicator, and other forward looking indicators in Australia suggest a pipeline of further weakness on the way, but we wonder if AUD will respond to the same degree to market panic as it has in the recent past. The likes of EURAUD and GBPAUD have come well off their recent highs, though JPY strength would probably spell the worst trouble for AUD, should it return.

Backgrounder: A report from a study done by the Depository Trust and Clearing Corporation was released this week with the purpose of allaying fears about the level of credit related risk in the market. It showed a total of $33.6 trillion of CDS contracts outstanding, but some are criticizing the study because it may not include up to 40% of the transactions that took place, especially those written by AIG and other counterparties. This all means, in other words, that the financial weapons of mass destruction are still very much out there and circulating and we could have more ugly revelations in coming months. AIG continues to burn through government money like there is no tomorrow - $90 billion in the last seven weeks alone and about 1% of US GDP in total so far! The company could continue to be a conduit for the US treasury bleeding money in a roundabout way back to the financial industry, who used AIG to hedge against a fall in its asset backed CDO's and other instruments. One wonders if this is the most efficient way to use taxpayer money. Also, AIG will be forced to liquidate its enormous assets and probably won't exist in a couple of years. The fiscal implications of all of this are nightmarish and eventually add to the real problem for the USD - but that is way off in the distant future somewhere....for now, the USD looks strong as long as risk aversion is on the front burner.


We have a look again at the very technical EURUSD chart, where the action has found resistance twice at the 21 day moving average. Any rally will focus on that level as first resistance. 1.2795 is the first support, followed by the rising consolidation line, currently coming in around 1.2630.


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