Expect Consolidation in Currencies

Over the past six weeks, foreign exchange and short-term interest rate markets have made significant adjustments. The way prices have responded to the latest economic data warns that this adjustment process is largely complete. This suggests that a period of consolidation lies ahead, during which some of the recent trends may retrace. At the same time, though, a phase of consolidation is still conducive to selective carry trades.

A significant adjustment has taken place in the market's expectations for the trajectory of Federal Reserve policy. The market has gone a long way toward pricing out not only a cut in the first quarter but in the second as well. The shift in expectation for the first quarter is clear in the fed funds futures contracts, where yields in January-April contracts are within half a basis point of the current fed funds target of 5.25%.

The relative lack of activity in the further-out contracts suggest the eurodollar futures may be more useful in getting a handle on second-quarter expectations. The June eurodollar futures peaked in early December and have fallen sharply since. The implied yield has risen from 4.775% to 5.35%.

At this juncture, it seems unreasonable to expect the pendulum of market sentiment to swing in favor of a hike, though I continue to highlight this risk while recognizing that chances of it happening in the first half of 2007 are slim. This would suggest then that the interest rate adjustment is probably complete, and that in a consolidation/corrective phase, the June Eurodollar futures may firm and short-term rates may drift slightly lower.

A Stronger Euro

In this scenario, the market is likely to respond more positively to poor news, such as disappointing economic data, than it is to react negatively to stronger-than-expected data. Technical indicators are consistent with this fundamental story and warn of a loss of downside momentum in the June eurodollar futures contract.

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Marc Chandler has been covering the global capital markets in one fashion or another for nearly 20 years, working at economic consulting firms and global investment banks. Currently, he is the chief foreign exchange strategist at Brown Brothers Harriman. Recently, Chandler was the chief currency strategist for HSBC Bank USA. He is a prolific writer and speaker and appears regularly on CNBC. In addition to being quoted in the financial press, Chandler is often a guest writer for the Financial Times. He also teaches at New York University, where he is an associate professor in the School of Continuing and Professional Studies. While Chandler cannot provide investment advice or recommendations, he appreciates your feedback; click here to send him an email.