Has the US Dollar Hit a Bottom?
The most commonly asked question in the currency market these days is “When Will the US dollar Reach a Bottom?” Every time we have any sort of mild dollar rally like the one we had today, everyone wonders whether this will be the end of dollar weakness. Over the past week, we had relatively positive US economic data suggesting that a bottom may be likely; GDP growth was the strongest since 2006, non-farm payrolls doubled its forecast and contrary to market expectations, service sector activity accelerated according to the non-manufacturing ISM report.
However many people remain worried that the US economy still faces problems. The financial sector is in disarray with banks reporting much larger than expected write downs last quarter and CEO’s leaving left and right. Jim Rogers and Bill Gross have both warned that the subprime crisis is far from over, and the threat of higher gasoline prices and winter heating costs leave recession a realistic possibility. Yet, recent comments from Federal Reserve officials suggest that even if this is the case, they may not continue lowering interest rates. Fed Governor Mishkin said today that should the latest interest rate cut by the Federal Reserve prove unnecessary, it “could be removed.” Mishkin voted in favor of lowering rates last month, Hoenig was the one who dissented. His comments today reveal more on why the Fed decided to lower rates because according to Mishkin, the “potential costs of inaction outweighed the benefits.” It is becoming increasingly clear that getting the Fed to consent to another interest rate cut will be like pulling teeth. However traders are expecting a rate cut. Fed fund futures are now pricing in a close to 100 percent chance that US interest rates will be 4.25 percent by the end of the year. The situation that we have now is one where traders and investors think that the Federal Reserve needs to continue cutting interest rates but the Fed does not want to do that; therefore whichever party manages to convince the other by December 11 will decide whether the US dollar has bottomed.

Euro: Rate Hike, Rate Hike, Rate Hike
The financial markets are finally waking up to the possibility of an interest rate hike by the European Central Bank. Although a rate hike has not been priced in for this week’s monetary policy meeting, there is a growing possibility that ECB President Trichet could notch up his degree of hawkishness by bringing back the words “strong vigilance.” We have been talking about this scenario for weeks and relating the ECB decision to the recent decision by the central bank of Sweden to increase interest rates. Inflation has become a major problem with the annualized pace of consumer price growth jumping to 2.6 percent, well above the ECB’s 2 percent inflation forecast. If the Reserve Bank of Australia raises interest rates tomorrow night, it will be further evidence that major central banks are not afraid to increase interest rates in the current market environment. There was no Eurozone economic data released this morning, but service sector PMI, PPI and retail sales are due for release tomorrow. We are expecting stronger inflation numbers, decent retail sales and stable service activity.

USD/CAD Sinks to New Record Low
The Canadian and New Zealand dollars were the only currency pairs to rally against the US dollar today. The fact that commodity prices were slightly lower and there was no Canadian data released indicates that the move in USD/CAD is driven by momentum, flow and speculation that tomorrow’s building permits and IVEY PMI will be strong. The Canadian economy has proved to be far more resilient than any of us could expect so it would not be surprising if the manufacturing and housing market reports confirmed this. As for the New Zealand dollar, stronger labor costs in the third quarter gave the currency a good reason to outperform the US and Australian dollars. Unfortunately the Aussie did not participate in this rally; many traders find it hard to believe that the RBA will be raising interest rates later this week. Overall the Australian economy remains strong. Even though service sector PMI was softer last month, job advertisements increased 2.7 percent and the TD securities inflation index ticked higher.

British Pound Finally Succumbs to Weaker Economic Data
After rising for seven days in a row, the British pound finally succumbed to weaker economic data. Service sector PMI and industrial production all fell short of expectations illustrating the difficult time that UK manufacturers are having with the high value of the British pound. Like the ECB, the Bank of England will also be meeting to decide on interest rates. If they leave monetary policy unchanged, no statement will be released. We suspect that tomorrow’s UK GDP number could be softer as well, but the biggest driver of pound strength or weakness is not UK fundamentals but US fundamentals. According to our Technical Analyst Jamie Saettele, the GBP/USD is poised to take out 2.10.

Carry Trades Up One Day, Down the Next
The Japanese yen crosses have been range bound for the past few trading days and the latest wave of weakness came from the sharp selling of Asian equities overnight. China put their plans of allowing their citizens to invest in the HK stock market on ice, causing the Hang Seng to drop 5 percent. To put this into perspective this would represent a 675-point down move in the Dow. There was no Japanese economic data released last night and leading indicators are the only data due for release this evening. As usual, Japanese yen traders should continue to watch the equity markets for more direction.

Kathy Lien is the Chief Currency Strategist at FXCM.