Markets to Consolidate This Week After Fed's Discount Rate Cut

Fed's 50 bps discount rate cut on Friday stabilized the markets which was in massive carry trade unwinding as the subprime mortgage crisis spread through global credit markets. But still, the ultimate carry trade pair, NZDJPY tumbled near to 10% while AUD/JPY also dropped close to 9%. High yielding currencies and European majors except the Swissy, were hammered much lower too before late Friday's recovery. Important technical levels were taken out in most pairs that signaled at least a medium term reversal. However, as a short term top/bottom should be in place after Fed stepped in, and with a rather light calendar, more consolidation could be seen this week before extending the reversed trend.

The greenback did ride on carry trade unwinding and surged against most currencies except the yen on flight-to-safety flows. Fed's unexpected discount rate cut from 6.25% to 5.75% has stabilized the financial markets and triggered some retreat in the greenback too. To be clear, the discount rate is the rate that the Fed charges to lend money directly to banks and other lending institutions. Meanwhile, the commonly talked about Fed Funds Rate is that the rate that banks ay to borrow from the marketplace. In addition to lower the rates, the Fed also allow terms of financing to extend to 30 days. Most importantly, in the statement, the Fed acknowledged that "Financial market conditions have deteriorated, and tighter credit conditions and increased uncertainty have the potential to restrain economic growth going forward". Downside risks to growth have "increased appreciably". Altogether, even though the act did stabilized the markets and suggest that Fed is openings door to turning bias to neutral and even pathing the way to a Fed Fund rate cut, it is taken as a confirmation of the acknowledgement of the seriousness of the subprime problem. In other words, more bad news could still come in the near future and markets will continue to be vulnerable to them. The discount rate cut, and even a Fed Fund rate cut could halt the current liquidation of riskier assets but the trend will likely continue.

One thing to note is that the Swiss Franc is relatively less affected by the massive carry trade unwinding due to its low yield status. Even though it ended lower against the dollar, the Swissy did rose against both Euro and Sterling. The late buying in Swissy is perhaps an indication that more carry trade unwinding with Swissy is around the corner.

Economic data played a secondary role last week. Though, housing data from the US did showed further deterioration in the housing markets. Housing starts in US dropped much fore than expected to an annual rate of 1.381m in Jul, from 1.47m. Building permits also dropped to a 10 year low of 1.373m. From the data, in addition to NAHB Housing Market Index which fell to a 20+ record low, there is no signal of bottoming of the housing market yet. Consumer inflation data from US were inline with expectation with headline CPI moderated to 2.4% yoy, core CPI staying at 2.2%. PPI was mixed with headline number accelerated to 4.0% while core PPI moderated to 2.3%.

However, Trade deficit surprised the market by dropping to -$58.1b. Capital flow remained near to record at and dropped slightly to 120.9b only, partly reflecting flight-to-safety flows. Retail sales rebounded by rising 0.3% mom with ex-autos rising 0.4%. Regional Fed survey were mixed with NY state index at 25.1 while Philly Fed index dropped to 0.

Data from Eurozone saw Q2 GDP rose 0.3% qoq, 2.5% yoy, down from prior 0.7%, 3.1%. Jul HICP confirmed to be -0.2% mom, 1.8% yoy. There were speculations that with below target inflation and risk of subprime problems' spread over to Europe, ECB could call off it's expected Sept rate hike.

In addition to carry trade unwinding, Sterling was also hammered after UK CPI eased to 1.9% in July, down from 2.4% June, and being lowest in 15 months. Most importantly, the inflation rate was below BoE's target rate of 2.0%. The quarterly inflation report released earlier this month forecasted another hike to 6% is needed to bring inflation back to 2%. However, this week's CPI report is putting much doubt to this forecasts. Also, BoE Minutes revealed MPC elected to hold its benchmark interest rate at 5.75% in August unanimously by 9-0 vote, inline with consensus. One of the main focus in the minutes was indeed that that most members had 'no firm view' on the need for further rate hike. From the employment report, unemployment held steady at 5.4% for the second month in a row in June. However, earnings growth continues to report a slowdown and moderated from 3.5% to 3.3%. Markets were paring bets on another hike in near term.

Japan's Q2 GDP rose 0.1% Q/Q only with annualized rate at 0.5%. GDP deflator remains weak and dropped -0.3% yoy. There is also speculation that BoJ will further delay another rate hike due to current turmoil in the financial markets.

Commodity currencies remains under tremendous pressure last week. In addition, Kiwi will further sold off after June retail sales dropped unexpectedly dropped -0.4%.

The Week Ahead

With Fed's discount rate cut, markets are expected to calm down this week and turn into consolidation. Economic data may be back into focus but the impact will still be limited and markets are still nervous on further development of the credit crisis. From US, the mostly watched data will be durable goods and new home sales on Friday. From Eurozone, German ZEW will be the focus of the week and is expected to deteriorate sharply from 10.4 to -2. From UK, more house prices data will be released during the week but focus should be on Q2 GDP on Friday. BoJ will also announce rate decision on Thursday but is expected to remain on hold at 0.5%. Canadian consumer inflation and retail sales will also be featured.

USD/JPY

USD/JPY's sharp decline from 124.13 resumed last week and extended even more steeply lower to as low as 111.59. In the bigger picture, decisive break of long term rising trend line (101.65, 108.99, now at 116.21) indicates the the whole up trend from 101.65 could also have completed at 124.13 already, with bearish divergence condition in daily MACD and RSI. Also, note that 55 Months EMA (now at 115.56) was also taken out too. The current decline is expected to extend further to support zone between 108.99 and 61.8% retracement of 101.65 to 124.13 at 110.23 before turning into lengthier consolidation.

In the longer term picture, the three wave structure of the up trend from 101.65 to 124.13 suggest that it's corrective in nature. Suggest development flipped favor to the case that the rally from 101.65 could indeed be the final leg of a long term triangle formation (147.68, 101.22, 135.20, 101.65, 124.13). The break of falling trend line (147.68, 135.20) was merely a throwover in the last leg. Sustained trading below 108.99 low will add more credence to this case and put key long term support zone of 101.22/65 into focus.

A lot of volatility in the USD/JPY last week. Strong rebound from 117.15 was limited by 119.81/89 cluster resistance (100% projection of 117.15 to 119.07 from 117.97 at 119.89 and 38.2% retracement of 124.13 to 117.15 at 119.81), followed by equally sharp fall. However, the downside of subsequent decline was contained above 117.15 and recovered strongly on later Friday session. After all, the price actions indicated that a short term low is in place at 117.15. Subsequent consolidation is still in progress and another test of 119.81/89 cluster resistance would be seen before resuming the fall from 124.13.

From a short term angle, a short term bottom is in place at 111.59 after touching of mentioned 114.63 resistance. Further consolidation should be seen this week but upside is expected to be limited below 117.15 support turned resistance. Below 113.07 will bring retest of 111.59 low and break will bring another fall towards next medium term target of 108.99 (06 low). Above 114.63 will indicate stronger rebound is underway first.

Read full report (EUR/USD, GBP/USD, USD/CHF, USD/JPY, EUR/JPY) here.

Shing-Ip Tsui is the founder and CEO of www.ActionForex.com. ActionForex is set up with the aim to empower individual forex traders by providing insightful contents. Analysis reports, live pivot points on majors and crosses, etc are provided with collection of carefully selected educational articles and free trading ebook downloads.