US Dollar: Volatility Rocks the Markets as Expectations for an October Cut Rises
Sharp moves in US equities triggered widespread volatility across the financial markets. The US dollar has strengthened because it tends to benefit in environments of rising risk aversion where we see traders and investors move back to cash and into the safety of the US dollar. Market sentiment has also shifted over the course of a few trading days even though economic fundamentals have not. Fed fund futures have gone from pricing in a 32 percent chance of an interest rate cut at the end of the month to 45 percent, leaving many traders wondering what has changed. Consumer price growth this morning was tepid while housing starts and building permits were horrid. The housing market continues to struggle as starts and permits fell to the lowest level in 14 years. Although it can be argued that the CPI numbers gives the Federal Reserve more leeway to lower interest rates, traders cannot ignore the fact that the price of oil is on its way to $90 a barrel. Refineries have shielded US consumers from the higher costs by taking a hit to margins; this type of trend is not expected to last. With gasoline prices well off their May highs, consumers will have to shoulder some of the burden eventually. At that time, higher inflation pressures will manifest themselves. With inflation risks skewed to the upside, the Fed will find it difficult to lower interest rates even though the latest Beige Book says that economic growth has slowed since August. Slower economic growth and faster inflation is the definition of stagflation, which was last seen in the 1970s. At the time, the Federal Reserve Chairman Volcker increased interest rates from 4.75 to 20 percent over the course 3 years to combat double digit inflation. Of course, we are far away from double digit inflation levels at the moment, but the risk of inflation rising should at least keep the Fed hawkish. Therefore we do not expect the Fed to ease.

Carry Trades Take Another Beating
Continued weakness in the Dow has led to continued weakness in the Japanese yen crosses. Last night, the Nikkei tracked US equities lower driving carry trades to 10-day lows. These losses were recovered when the Dow opened up 60 points, but the sharp intraday reversal in US stocks triggered another wave of selling. Risk aversion is certainly part of the problem, but part of the move may also be due to the expectation that the G7 could institute tougher language towards the Japanese yen and the Chinese yuan. Recent comments from Eurozone and US officials seem to indicate that the yen will become the scapegoat for dollar weakness and Euro strength. For the Europeans, getting the yuan and yen to strengthen would at least help to lower the value of EUR/JPY. In the meantime, it is important to remember that the weakness of the Japanese yen will continue to bring benefits to Japan’s economy. The tertiary activity index was stronger than expected in the month of August.

Oil Hits Record Highs and then Reverses: What Does that Mean for CAD?
Canadian dollar traders cannot stop thinking about the possibility of $100 oil which is why the CAD remains strong despite weaker economic and an intraday reversal in oil prices. Oil prices hit record levels following news that Turkey will be making an incursion into Iraq. Prices, however, reversed shortly afterwards when inventories were stronger than expected. Although it is a fool’s game to try to pick a bottom in USD/CAD, a bottom is a growing possibility now that we are finally seeing evidence that oil prices may be topping and the Canadian economy may be weakening. Wholesale sales tend to be a good leading indicator for retail sales which makes today’s surprise 2 percent drop worrisome. The Australian and New Zealand dollars have also seen great volatility; the end of day bounce in equities has helped both currencies recover.

Euro Still Stuck in a Range; SNB Roth Says Do Not Rule Out Rate Hike
In a market that is flush with volatility, the Euro has become the most uninteresting currency to trade. Since the middle of last week, the EUR/USD has been stuck within a 100 pip range. The ECB has not wavered in their hawkish tone which is a strong signal to the market that the central bank has no plans to intervene in the currency or to lower interest rates. The latest comments come from Liebscher who said that significant inflation risks remain. He is firmly convinced that Eurozone growth is ongoing and rather robust. The trade balance is the only number due from the Eurozone tomorrow; if the strength of the Euro was to have any impact on economic data, the most obvious would be trade. It is also important to note that Swiss National Bank President Roth told the markets not to rule out an interest rate hike, which should be a long term positive for the Swissie.

British Pound Benefits from Stronger Employment Data
The British pound was probably one of the best performing currencies today. Even when the sharp weakness in the Dow caused a sea of red in the foreign exchange market, the British pound held strong against the US dollar. Given that the Bank of England minutes were mixed, this strength most likely stemmed from the stronger employment numbers. The amount of people claiming unemployment fell by 12.8k last month, which was four times greater than the market’s expectations. Average wages also climbed, which suggests that tomorrow’s retail sales numbers could be stronger than expected. As for the BoE minutes, the committee voted 8 to1 to leave interest rates unchanged. They were concerned about the impact of the credit markets and even considered a precautionary rate cut, but growth had not slowed enough to warrant one and inflation is still projected to remain near their 2 percent target.

Kathy Lien is the Chief Currency Strategist at FXCM.