Forex Investment and Currency Trading

The immediate market reaction to the collapse of Lehman’s rescue talks and subsequent Chapter 11 filing was to sell USD and buy the JPY-crosses at the Asian open. However, through the London morning, USD has rebounded leaving EUR/USD only marginally higher than the North American close on Friday. Generally, this knee-jerk reaction to sell USD is probably the wrong one. FX markets are likely to be dominated by liquidation of positions and risk reduction in the short term. In recent sessions, this “deleveraging” has tended to be USD positive and if we see large scale repatriation - for example, through US mutual fund redemptions - there may well be a natural buyer of USD.

The greater risk is in high/low yield currency pairs, particularly the JPY-crosses. Given the huge overhang of long AUD/JPY and NZD/JPY positions on the part of Japanese retail investors, and the fact that Tokyo was closed overnight, there is a significant risk of forced liquidation/margin calls in the these currency pairs in the next few sessions. The greater risk is in NZD/JPY where positioning is most extended and liquidly thinnest. Elsewhere, other obvious risk proxies - GBP/CHF for example - are also likely to remain pressured, though without the overhang of positions that afflicts the JPY crosses, the risk of violent moves lower is more limited.

Aside from the asset market reactions to the weekend’s events, the other key driver of markets will be the outlook for US rates heading into tomorrow’s FOMC announcement. The pressure on the Fed to deliver a confidence-boosting rate cut tomorrow has intensified (Fed Funds pricing in a 70% chance of a 25bp cut vs. 12% on Friday).

Market argument is that, having front-loaded its policy response, the hurdle to cut further (and to edge toward a BoJ-style scenario of 0% rates) is high and, given the cost of money is the result and not the cause of the ongoing crisis, the FOMC might confine its actions to boosting its liquidity support programme. That said, the risk of exacerbating market uncertainty via a steady rate decision is high (i.e. a cut might not improve matters but no move will make them worse). By the same token, a “modest” 25bp ease will do little to shore up sentiment given this outcome is already largely priced in. In light of these concerns, the two most likely outcomes to the FOMC meeting market sees now are no change or a 50bp cut (the latter possibly being delivered today should the market show yet further immediate weakness).  There is every likelihood the Discount rate will be brought in line with the Fed Funds target rate regardless of whether a cut is delivered.

USD/CAD is being driven wholly by broad USD swings. Having initially sold off to 1.0572, USD/CAD has rebounded and like EUR/USD is close to Friday’s closing levels. Needless-tosay, domestic data flow in Canada is likely to remain a secondary driver this week.