US Dollar Beaten to a Pulp; Is Euro 1.50 Next?
The US dollar succumbed to heavy selling on the last trading day of the month, which also happens to be the last trading day of the quarter. As the value of the once mighty buck continues to fall, other currencies have hit multi-decade highs. More specifically, the Euro rose to a record high while the Canadian and Australian dollars hit 31- and 18-year highs respectively. Although we saw evidence of improvements in the manufacturing sector today (Chicago PMI and Construction Spending surprised to the upside), there are still plenty of reasons for concern. Personal income growth slowed as spending increased while the PCE deflator moderated. Collectively, this data reinforces the need for the Federal Reserve to lower interest rates at the end of next month. However we do not expect anything more than a quarter point rate cut since the rise in commodity prices and the fall in the US dollar has put upside pressure on inflation. Slower growth and rising inflationary pressures resurrect the risk of stagflation. The last time we had serious stagflation problems was in the early 1980s. With the Euro taking out 1.42 and on its way to 1.43, the burning question on everyone’s mind now is whether we will hit 1.50. Although the weakness of the US dollar will eventually help engineer an economic recovery, there is no reason to believe that the relief will come anytime soon. Euro 1.50 may be a lofty goal but 1.45 is certainly reasonable. Next week, we have a lot of economic data as well as three central bank interest rate decisions. The most important release out of the US will be non-farm payrolls. Everything else before it, including manufacturing and service sector ISM will simply be used to help forecast whether payrolls will be weak or strong. The market is currently looking for very optimistic 100k job growth. We think that this is overly ambitious given the layoffs announced in the financial sector and the big losses reported by home builders. Some people have argued that yesterday’s jobless claims report was bullish, but just because companies are not firing does not mean that they are hiring. For most companies, expansion is probably the last thing on their minds at the moment.

Euro: Will ECB Trichet Recognize the Pain?
Despite the European Central Bank’s reluctance to acknowledge the impact that a 1.43 Euro has on economy, the damage can already be seen. Earlier this week we had softer inflation and weaker confidence reports. Today German retail sales dropped 1.4 percent despite the fact that unemployment hit a 14-year low. Unsurprisingly, confidence in the region as a whole also deteriorated. The EU’s Junker has already said that the strong Euro is starting to be a great concern for the group. It seems to be only a matter of time before ECB President Trichet makes a similar comment. Why has the ECB been so stubborn? Today’s 2.1 percent flash estimate of consumer prices is a good reason. This is the first time in over a year that inflation has rose above their 2 percent target. Even though the rising Euro is suppose to reduce inflationary pressures, the even stronger rise in commodity prices is offsetting that impact. The ECB has a monetary policy meeting next week. Interest rates are not expected to be changed, but as usual keep an eye on the comments that ECB President Trichet makes at the accompanying press conference. He is definitely not expected to bring back the words strong vigilance, but at the same time, he may not be able avoid making cautionary or dovish comments particularly since many banks have been borrowing at the ECB’s penalty rate indicating that the credit markets have far from stabilized.

Canadian Dollar Hits 31-Year High, Australian Dollar at 18-Year High
Commodity currencies performed extremely well today with the Canadian dollar hitting a 31-year high and the Australian dollar rising to an 18-year high. Oil reversed intraday, but gold prices have run up to a 28-year high of $750 an ounce. The Canadian dollar is trading almost exclusively off of momentum. GDP was softer than expected in the month of July while the price of industrial product and raw materials abated. This should have been bearish for the Canadian dollar but rising commodity prices and a weaker US dollar actually drove the loonie higher. IVEY PMI and Employment are due out next week so expect the Canadian to continue to receive big focus. As for the Australian dollar, the rally has now extended for the ninth consecutive trading day thanks to the surge in gold prices. Australia has retail sales and the RBA interest rate announcement next week. Interest rates are not expected to be changed and spending is expected to pare back after a big jump in July. As for New Zealand, the kiwi rose strongly after solid GDP numbers. There is no data due out next week.

British Pound Trading Near 2.05
The British pound continued higher today and came within a whisker of 2.05 despite weaker consumer confidence and news that Northern Rock borrowed another GBP5 billion from the Bank of England. The UK banking sector is still in trouble, but this seems to matter little for traders who are obsessed with selling US dollars. However these problems raise the risk of a surprise interest rate cut from the Bank of England next week. The BoE is notorious for catching the market off guard and given the continued problems at Northern Rock, they may feel the need to ease monetary policy. Aside from the BoE meeting, we are also expecting manufacturing and service sector PMI data.

Japan Still Faces Deflationary Conditions
The Japanese Yen continued to weaken on evidence that deflation remains a problem. Although retail sales increased in the month of August, the drop in consumer prices, rise in unemployment and deterioration in industrial production will prevent the central bank from raising interest rates anytime soon. Next week we have the Tankan due for release. This quarterly report is usually one of the most market moving indicators for Japan. However the Dow seems to be the bigger focus for Yen traders at the moment and we do not expect that relationship to change anytime soon.

Kathy Lien is the Chief Currency Strategist at FXCM.