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%.