US Dollar Recoups Some Losses, But Concerns of an August-Style Credit Crunch Loom Large
The US Dollar made solid headway higher on Monday, but with little fundamental impetus other than simple short covering following the uneventful G7 meeting, the move highlights the speculative nature of the markets. Fed fund futures currently price in a 86 percent chance of a rate cut by the Federal Open Market Committee on October 31st, up from 78 percent this morning but down from 92 percent on Friday. At this juncture, the central bank has been giving very mixed signals, as their previously hawkish stance has been toned down significantly and instead has shifted to focus on economic conditions. Furthermore, while the health of the financial markets is clearly of importance to the Federal Reserve, the matter of whether the bank is essentially “bailing out” the stock markets and companies that irresponsibly got caught in the borrow-short-lend-long squeeze during August is still being debated. Indeed, when the Dow plummeted more than 2 percent last Friday, expectations of a 25 basis point cut at the end of the month rocketed higher. What about that pesky inflation issue? Headline CPI has climbed to an annualized rate of 2.8 percent on the back of food and energy prices. However, energy prices aren’t just high – oil continues to trade near record highs – and food prices haven’t ticked up – wheat futures rocketed to a record in September. Nevertheless, Federal Reserve Governor Frederic Mishkin said over the course of the weekend that core inflation measures, which exclude food and energy costs, are a “better guide” as they “provide a clearer picture of underlying inflation pressures.” With core CPI holding relatively steady at an annualized rate of 2.1 percent, Mishkin’s comments suggest that the FOMC potentially has more room to cut rates. However, it is worth noting that core CPI also happened to be stable at these levels throughout late 2004 through early 2006 – the same period of time that the FOMC was aggressively raising interest rates. As a result, there may be good reason for all this confusion over the Fed’s policies, especially as additional rate cuts may confirm one of the biggest fears of the markets: the potential for another August-style credit crunch may be greater than many would like to believe.

British Pound: Two UK Bank Seek Emergency Funding, But Not From The BOE
The British Pound tumbled significantly, and while the move was generally the result of US Dollar gains this morning, news that two of the UK’s biggest banks were seeking emergency funding did little to aid the currency. Barclay’s and Royal Bank of Scotland will borrow a total of $30 billion, sparking additional worries that the UK financial markets remain distressed. What may be most disconcerting, however, is that these banks are borrowing from the US Federal Reserve, not the Bank of England. The funds are said to be used as contingency funding and may not even be utilized if conditions continue to improve. Nevertheless, it is clear that the Bank of England remains reluctant to provide liquidity to the UK markets in fear of the potential for moral hazard to come into play. If the central bank has not sought to accommodate the markets during the tightest of credit conditions, there is very little chance that the BOE will move to cut rates in the near term.

G7 Meeting: Status Quo Commentary Gives Carry Trades the Green Light
The G7 meeting of finance ministers over the course of the weekend resulted in little fanfare, as the communiqué signaled that there was no intent on any official’s part to stem the rapid depreciation of the US Dollar. In fact, much of the statement proved to be no different from previous meetings, noting that exchange rates should reflect economic fundamentals and that excess volatility in foreign exchange markets is bad for global growth. Unsurprisingly, the only direct commentary was in regards to China, as the communiqué noted that the country’s current account surplus was evidence of the need for a stronger yuan. Nevertheless, with China likely to continue taking their slow and steady approach to allowing the yuan to appreciate, the G7 has effectively given traders the green light to keep carry trades in play.

Euro: ECB Acquiescent in the Face of Appreciation
With the G7 communiqué failing to address the depreciation of the greenback and the rapid appreciation of the Euro, it appears that the European Central Bank and European finance ministers have resigned to the currency’s strength. However, ECB President Jean-Claude Trichet clung to US Treasury Secretary Henry Paulson’s “strong dollar policy” comments, though this particular statement has done very little for the greenback in the past and is highly unlikely to anything for the currency in the future. As a result, any bullish economic data out of the Euro-zone or remotely hawkish commentary from ECB officials over the course of the next week may only serve to provide a bid tone for the Euro.

Kathy Lien is the Chief Currency Strategist at FXCM.