NEWS / Foreign Exchange

Yield Curve Normalizes as Fed Neutralizes

No dollar reaction to the lower than expected weekly jobless claims release showing a drop to 316K, udnershooting expectaions of 323K from 320K.

Markets realize it was an overreaction

The dollar rebounds off its post-FOMC lows as traders reevaluate the excessive selling in the US currency based on what we deemed was an overreaction to the FOMC statement. Although the Fed discreetly toned down its view of recent data and downgraded its assessment of the US housing market, the inflation vigilance remained largely intact.

Fed lifts foot off break but still away from gas pedal

The Fed's replacement of the phrase ???additional firming??? with ???Future policy adjustments??? does not constitute an explicit abandonment of the tightening bias because of the maintenance of the inflation vigilance, which in fact was stepped up from the January statement. Replacing the inflation reference, which stated ???improved modestly??? by ???somewhat elevated??? is a continuation of the Fed's vigilance of price pressures. For this, we deem the statement as a subtle move to neutrality, with a touch of inflation concern.

Fed does not have to signal easing bias before cut

While it is preferable that the Fed signals it's a shit towards an easing directive, it has shown in the past that it could move directly from neutral bias to an actual rate cut. This was proven in the January 2001 rate cut, which was the first reduction of the 2 ?? year easing cycle. The fact that there is no FOMC meeting in April could see the Fed move towards a May cut in the event of a deterioration in market and  economic conditions, accompanied with two consecutive monthly increases in the unemployment rate (March and April rates to be released next week and just before the May FOMC meeting).

Normalization of yield curve opens way for May rate cut

The normalization of the yield curve signaled by 10-year yields matching (and briefly rising above) 2-year yields reflects the bond market's gradual shift towards expecting a 2007 easing. The 10-2 year yield spread became positive during the stock markets sell-off and surge in volatility between April and May of last year before turning negative again. Further increase in 10 year yields above their 2-year counterpart would signal an increase in bond markets' expectation for Fed easing. This will largely depend on the incoming data and especially the Federal Reserve speeches in April.

Our expectations since December for a Q2 Fed easing remain intact. We lift probabilities of a May rate cut to 75%, with the 2007 easing expected to be an aggregate of 75 bps to 4.50%.

The 10 am EST release of the February index of leading economic indicators is expected to show a drop of 0.4% following 0.1% and 0.6% in Jan and Dec respectively.

Yen drops as BoJ makes its own dovishness

Euro short-term chart suggests 1.3340

Cable profit-taking vulnerable to 1.9620

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