Forex Investment and Currency Trading

In a historic move, the FOMC announced yesterday that it is going to “establish a target range for the federal funds rate of 0 to 1/4%,” thereby cutting the target rate at least 75bp and acknowledging that in the current environment it has limited control over the effective funds rate.  Even more aggressive was its statement, which shifted the focus of policy to financial market interventions. It indicated specific asset classes that it would support (agency and mortgage debt), but maintained considerable flexibility, saying it would explore the benefits of buying long-dated Treasury securities. The statement also mentioned the TALF, which it hopes will “facilitate the extension of credit to households and small businesses.”

Perhaps the most important part of the statement was the explicit commitment to an extended period of low rates, which is weighing significantly upon the USD. Market remains bearish on the USD for 2009, given the perfect storm of loose fiscal policy, loose money and a persistently large US current account deficit that awaits the USD next year. However, one is less convinced that a large further USD decline awaits us over the next few months. The Fed’s intention to buy US assets in a world that is rapidly falling into recession and where deflation is far bigger risk than inflation, means that US assets will look attractive relative to elsewhere. Even though the one US asset the Fed is not explicitly supporting is the US dollar, their commitment to support other asset prices should reduce the risk of a run on the USD.

Another critical factor for FX will be how other central banks respond. In particular, the ECB and BoJ are facing rapid appreciation in their currencies because of the aggressive actions taken by the Fed. Overnight, the Nikkei reported Japanese FM Nakagawa as saying the MoF is not considering FX intervention, although he later commented that they will take all steps on the economy, including dealing with rapid FX moves. There is unlikely to be intervention in the JPY market yet, although the risk of this will increase significantly if USD/JPY moves sharply below 85. In addition, aggressive policy measures have reduced the tail-risk associated with financial markets. As such, while traders remain positive on the JPY, they do not expect the appreciation to be disorderly and large.

The situation is potentially even more problematic for the ECB, which has struck a more hawkish tone than other central banks recently and contributed to the sharp appreciation in the EUR trade-weighted index in December. The Fed’s move has exacerbated the EUR move (TWI is now only about 3% below its highs) and arguably makes the exchange rate a concern for the ECB at a time when the flow of euro area data remains extremely negative. This leads to a possibility that the ECB will begin to retract its recent hawkish commentary, which could potentially reverse some of the recent EUR gains. As such, an attractive short-term opportunity is to sell the EUR against currencies other than the USD. Such a position would benefit from a less-hawkish ECB, as well as a general catch-up of other currencies to the EUR rally against the USD.