US Dollar: 90% Chance for October Rate Cut
The price action in the financial markets this week is a testament to how quickly expectations and sentiment can change. We started the week with nearly everyone in the market agreeing that the Federal Reserve will not cut interest rates at the end of the month and now implied Fed Fund futures are pricing in a 90 percent chance of an October cut. Taking a step back, aside from US consumer prices, the data released this week in the US was mostly second tier, which means that they should not have been all that market-moving. So what caused the dramatic change in interest rate expectations? Continued weakness in the housing market, disappointing earnings in the banking sector and a 550-point drop in the Dow (Monday to Friday). With HSBC downgraded, Bank of America reporting a 32 percent decline in earnings and Wachovia reporting a 10 percent drop, the 20th Anniversary Week of Black Monday 1987 has proven to be as brutal on a point basis as many of the October crashes that we have seen in the past. The rise in oil prices creates additional risk for an already vulnerable US economy and calls for a recession are returning. More immediately however, we need to turn our focus to today’s G7 meeting. The communiqué should be released this evening. According to Dow Jones, the draft of the statement indicates that finance ministers will be calling for the Chinese yuan to increase more quickly in value. The Euro, US dollar, Japanese yen and the Dow will probably not be mentioned in the official statement. The biggest currency to be impacted will therefore be the Japanese yen. Next week, we have more housing market data from the US as well as durable goods due for release. The market’s primary focus will be on the following Wednesday’s October 31st FOMC meeting but don’t write off the potential for a continuation move in the equity and currency market if there are any additional surprises in the official G7 communiqué.

G7 Meeting: Clearest Trend is Yen Strength
The clearest outcome of the G7 meeting will be yen strength. Not one of the Japanese yen crosses have been able to escape the pressure of carry trade liquidation today since yen is seen as the proxy for Asia, which includes China. The Chinese however are not very happy with shouldering the blame for US dollar weakness. Earlier this morning, an advisor to the People’s Bank of China said that the Euro’s gains are an indication of a dollar problem and they will become increasingly concerned if the dollar continues to devalue. Are they signaling potential diversification or liquidation of treasuries? The movements in equities continue to be a predominant driver of the Japanese yen. If there is follow through selling in the Asian markets, carry trades could see further losses. Today’s sell-off in the Dow is the strongest since early August. Next week, we are expecting the merchandise trade balance, consumer prices and industrial production. The weakness of the Japanese yen should help to boost inflation, exports and overall manufacturing activity. However, whether this will matter to yen traders remains to be seen, as more volatility in equities could easily overshadow surprises in economic data.

Canadian Dollar Hits 33-Year High, RBNZ Rate Decision Next Week
The Canadian Dollar continues to rise and today we have finally broken through another milestone to hit a 33-year high against the US dollar. Despite the fact that USD/CAD fell from 1.06 down to 0.9950 in the month of September, Canadian consumer prices remain strong thanks to a tight labor market. Core prices grew by 0.4 percent last month while annualized headline prices increased from 1.7 to 2.5 percent. This indicates that domestic inflation must be strong if consumer prices are still rising despite the counteracting effects of a strong currency. Oil prices also hit $90 a barrel today which is continuing to fuel gains in the loonie even though prices have since retraced. Canadian retail sales are the only piece of market moving CAD data on the calendar next week. Given the sharp drop in wholesale sales, we also expect a downward surprise in retail sales. The Australian and New Zealand dollars did not join in the CAD’s rally today. In fact, they are down sharply particularly against the Japanese yen. Next week, the Reserve Bank of New Zealand will be meeting to decide on interest rates while Australia will be releasing consumer prices.

Euro: Another Record High, Further Gains in Store
The Euro climbed to another record high today despite weaker German producer prices. Unlike the French, the Germans continue to be very comfortable with the level of their currency as well economic growth. Today, the German Finance Ministry said in its monthly report that the available economic indicators suggest that the upswing remains intact and the financial market turbulence has not appreciable burdened the economy. This will be an important perspective to keep in mind ahead of next week’s German IFO report. The stability of analyst sentiment and the firmness of Eurozone exports could keep businesses optimistic, which would help to drive further Euro gains.

British Pound: Strong Economic Data Continues to Take the Currency Higher
The British pound is one of the strongest currencies in the foreign exchange market today. Better than expected third quarter GDP growth and the August index of services sent the currency pair to a 2-month high. We have had nothing but firm economic data from the UK this entire week, which means that the Bank of England will keep interest rates steady for the remainder of the year. Next week, we are only expecting the CBI industrial trends report, Nationwide house prices and BBA mortgage approvals. Continued strength in economic data could take the British pound back to its July highs against the US dollar.

Kathy Lien is the Chief Currency Strategist at FXCM.