Global FX

• The US dollar rebounded strongly after plunging to a record low of 1.6017 on April 22 against the euro on growing expectations that the Fed might pause after cutting interest rates this month while other central banks are at the start of their easing cycles.
• US economic reports released in the past two weeks were mixed. While US housing data continued to disappoint, other reports, including industrial production and durable goods orders offered a glimmer of hope that the US economy might be able to muddle through. Coupled with relative stability in financial markets, there is growing speculation that the Fed may pause after an anticipated quarter-point rate cut at the end of this month.
• In contrast, a slew of negative euro zone economic reports suggest that the euro region is not immune to a US-led economic slowdown. It would be difficult for the European Central Bank, which has been maintaining a hawkish rhetoric due to rising inflation pressures, to raise interest rates anytime soon.
• Relative stability in financial markets and a rebound in stocks also helped revive risk appetite, causing funds to flow out of the Japanese yen and Swiss franc, into higher yielding currencies such as the Australian and New Zealand dollars.
• In the event, the dollar surged about 1.5% against the euro in the past week to trade near 1.5630 on April 25. It was also up about 4% versus both the yen and Swiss franc. The fact that the euro failed to sustain above the 1.60 level, could it be a sign that the dollar is due for a reversal after being battered throughout the past year on easing interest rate expectations now that it is other countries' turn to cut interest rates?
• The Fed is widely expected to deliver another quarter point rate cut when it meets on April 29-30 to bring the fed funds target rate to 2%. What will it do afterwards is more uncertain. There are two possible scenarios. It could pause from easing to let the impact of past rate cuts work through the economy, or it could continue to cut rates.
• The first scenario is probable if credit conditions continue to stabilise and the economy shows no further signs of deterioration. While the strains in the credit market might have eased slightly after the Fed and other central banks launched various measures to inject liquidity into financial markets, investors are still jittery and could be subjected to unexpected shocks.
• Even assuming that the worst of the credit crisis is behind us, the US economy is still at risk of falling into deeper recession. As such, the Fed might have to deliver more rates in the months ahead. However, the magnitude of the rate reductions may be smaller, that is, 25 bp each time, and they may also be spaced out, that is, not at every upcoming Fed meeting.
• Across the Atlantic, ECB officials remain hawkish and warn of upside risks to inflation. Their warning is not without ground, with oil prices breaking more records and global food prices escalating. However, there are also signs that economic activities in the euro zone are slowing, confirming the view that euro zone consumers and manufacturers are not immune to a credit-induced slowdown. We still see the ECB start cutting rates sometime in the third quarter. The situation in the UK is similar as the British housing market is clearly slowing. The Bank of England has started easing rates and more reductions can be expected in the second half of the year.
  

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