Citigroup expects Fed rate cut, euro to strenghten

Tightening financial conditions have set the stage for early Fed easing according to Citigroup economists who believe that the euro will continue higher and reach levels above 1.40 while the dollar is seen declining to levels close to 110 against the yen.

The next step will be shifts in the policy outlook. Recently, Citi analysts penciled in an extra Fed cut no later than the September meeting and a full 75 basis points of easing in coming months.

Outside the United States, Citigroup analysts no longer expect the ECB, BoJ, BoE, and BoC to hike again this year, and have scaled back near-term tightening by the SNB and Riksbank. The market crisis is unlikely to prompt early easing outside of the United States, unless financial conditions deteriorate markedly further.

“We expect FX carry trades to unwind further on heightened risk aversion and expect risk premia on other assets to remain elevated compared to levels of a month ago. The extraordinary uncertainty and disruptions in financial markets mean that further changes in the policy and market outlook could prove large and abrupt, even over the near term,” note Citigroup analysts.

Citi economists expect a sustained broad-based USD depreciation, including further losses against the EUR. U.S. economic growth is slowing notably in the third quarter, as one-off boosts to second-quarter activity fade. Housing-market imbalances remain, pointing to deeper construction cutbacks, bigger housing price declines and subpar growth until at least mid-2008. Housing price uncertainty likely will feed ongoing concerns over subprime and credit markets. Finally, declining profit margins and slower potential economic growth suggest that U.S. asset markets will not offer risk-adjusted returns that are sufficient to finance the external deficit without further USD depreciation.

Euro-area economic activity slowed more than expected in the second quarter, indicating that the drag from monetary tightening, fiscal restraint and rising credit costs have eliminated the need for further ECB rate hikes. But export demand from oil producers and other emerging markets helps to cap downside growth risks. And, over the medium term, a number of trends should support the EUR. Global economic growth should continue to bolster commodity prices, emerging-world incomes and Europe’s exports. Moreover, labor market performance and cost trends hint at a longer-than-expected period of relatively rapid noninflationary expansion that would, over time, boost asset returns in the euro area.