Knowing the Known

Over the past six weeks, foreign exchange and short-term interest rate markets have made significant adjustments. The way that prices have responded to the latest economic data warns that this adjustment process is largely complete. This suggests a period of consolidation likely lies ahead, during which some of the recent trends may retrace. At the same time, though a consolidative phase is still conducive for selective carry trades.

A significant adjustment has taken place in the market’s expectations for the trajectory of Fed policy. The market has gone a long way toward pricing out not only a cut in Q1 but in Q2 as well. The shift in expectations in Q1 is clear in the Fed funds futures contracts, where yields in January-April contracts are within ½ a basis point of the current Fed funds target of 5.25%.

The relative lack of activity in the further out contracts suggests the Eurodollar futures may be more useful in getting a handle on Q2 expectations. The June Eurodollar futures peaked in early December and have fallen sharply since. The implied yield has risen from 4.775% to 5.35%. At this juncture, it seems unreasonable to expect the pendulum of market sentiment to swing in favor of a hike, though we continue to highlight the risk of such but recognize the chances in H1 are slim. This would suggest then that the interest rate adjustment is probably complete and that in a consolidative/corrective phase the June Eurodollar futures may firm and short-term rates may drift slightly lower. In this scenario, the market is likely to respond more positively to poor news, such as disappointing economic data, than react negatively to stronger than expected data. Technical indicators are consistent with this fundamental story and warn of a loss of downside momentum in the June Eurodollar futures contract.

This is important for investors and traders in the foreign exchange market because of the relatively high correlation between short-term US interest rates and the US dollar. Over the past three months, the dollar move in the same direction as short-term interest rates about 50% of the time against the euro and Swiss franc. The correlation is slightly better for the dollar against the yen and slightly lower for the dollar against sterling.

Of course, correlation does not mean cause. Nevertheless the recent pattern is compelling. The euro bottomed against the dollar most recently on October 13 near $1.2380. It proceeded to rally until Dec 4th near $1.3367 and has since fallen to record a low near $1.2870 on Jan 12th. The June Eurodollar futures recorded a low near 94.72 (5.28% implied yield) on October 25 and rallied to 95.22 (4.78%) on December 5. As noted above since then, the June Eurodollar futures contract has dropped 57 ticks. For the better part of the past three months, the euro’s gyrations against the dollar have largely mirrored changes in short-term U.S. interest rates.

The spread between short-term U.S. and European interest rates have also largely been driven by the direction of U.S. interest rates. The premium the U.S. offered over the euro-zone peaked in late October near 135 bp and on December 1 bottomed near 102 bp. As the dollar strengthened against the euro in recent weeks, the spread gradually widened to about 124 bp. The spread also appears to have lost momentum.

The implication of this analysis is that much of the good news for the dollar against the euro has also been priced in. This does not mean that the euro will hold above the $1.2870 area. Instead, the take away point is that the bulk of the euro’s decline is probably behind us and additional losses are likely to prove difficult to achieve and sustain.

Helped by the Bank of England’s surprise rate hike, sterling is the only major currency to have risen against the U.S. dollar in the opening weeks of 2007. Yet sterling’s inability to move higher despite a strong December retail sales report warns that there too the good news has already been priced in. Retail sales in December were the strongest in 18 months and more than twice as strong as a consensus of economists forecast. Sterling’s upside momentum against the dollar has faltered as the $1.9800 area has been approached. The multi-year high was set on December 1 just below $1.9850. The June short-sterling futures contract made a marginal new low for the move and than proceeded to reverse higher, to potentially record what technicians call a “key reversal” , which would point to near-term gains in short-sterling.

Just as sterling out-performed other currencies in recent weeks, it is likely to under-perform in the consolidative period we envision. We expect this to be especially true against the euro and the Scandinavian currencies, but less so against the low yielding Swiss franc and Japanese yen.

A consolidation of recent foreign exchange moves may still favor carry-trades where low yielding currencies are sold to finance the purchase of higher yielding assets. The Bank of Japan has disappointed the market for two months by not raising interest rates. The wide spread between Japanese interest rates and U.S., euro-zone, and UK rates for example encourage yield hungry investors to get in the game. A low volatility environment is also conducive for carry trades and such conditions continue to exist. Another consideration is liquidity and although it is more complicated, by most measures liquidity remains ample.

G7 officials, who meet early next month, seem relatively unperturbed by the weakness of the yen. This suggests that the risk of verbal intervention to stem the yen’s decline is modest. The biggest influence on short yen positions may come from the Japanese themselves. Ahead of the end of Japan’s fiscal year, on March 31st, it is not uncommon for Japanese investors to slow their purchases of foreign assets and to repatriate funds. The general pattern is for such fiscal year end portfolio adjustments to begin in mid- to late February. To be clear, a resumption of capital outflows is often seen at the start of a new fiscal year.

Technical readings suggest the yen is over-extended, but there is no sign that it cannot get more over-extended. The next level that has attracted interest is the JPY122 area, where the next level of option and stops are thought to be stacked. The JPY120 area, which acted as an important cap in Q4 2006 should not act as support.