What Does the Federal Reserve Think About the Dollar’s Weakness?
Being short US dollars has been the best trade in the currency market this year because it has fallen against everything in sight. Today, it dropped to a record low against the Euro and Canadian dollar and multi-decade lows against the British pound and Australian dollar. Even though our targets of 2.10 in the GBP/USD and 90 cents in USD/CAD have been reached, our targets of 1.50 in the EUR/USD and 1.0 in the AUD/USD have not. The latest acceleration in dollar weakness was triggered by comments from China’s Cheng Siwei who hinted that the Asian Giant may be diversifying their massive reserves out of “weaker currencies and into stronger ones.” Although Cheng Siwei tried to retract his comments shortly afterwards by saying that he did not mean China will buy more Euros, the damage was done. So how does the Fed feel about the latest dollar weakness? According to Atlanta Fed President Lockhart, the dollar’s decline is “manageable.” Other Fed officials speaking today were also not worried. Both Mishkin and Poole felt that the affect on inflation from the weak dollar was limited. Although the dollar’s weakness is inflationary, the US also needs a weaker currency to boost growth. General Motors reported one of its biggest quarterly losses ever while Toyota reported the sixth straight year of record setting profits. We are sure that the US auto manufacturer is not happy about being trumped by its Japanese competitor and further dollar weakness is exactly what GM needs to help regain its edge. Federal Reserve Chairman Ben Bernanke is scheduled to deliver a testimony to the Joint Economic tomorrow and his comments can easily exacerbate or reverse today’s decline in the US dollar. Unfortunately I do not expect him to say anything groundbreaking since they are stuck between a rock and a hard place. On the one hand, inflation is a serious problem with the US dollar weakening and oil prices not far from $100 a barrel, but on the other hand the banking sector is prone to further subprime losses. As a result, there really isn’t much that the Federal Reserve can do so they will probably sit tight, watch incoming economic data and buy time before their next monetary policy meeting on December 11. For more on the chance of the EUR/USD hitting 1.50, see our special report.

ECB Trichet Could Make or Break it for the Euro
Both fundamentally and technically, we continue to believe that there the EUR/USD will reach 1.50, but whether or not this will happen soon will be dependent upon ECB President Trichet’s comments tomorrow. Now that we have seen an interest rate hike from the central banks of both Sweden and Australia, the ECB won’t be alone in considering higher interest rates. We do not expect a rate hike to be delivered, but with inflation well above their 2 percent target, the ECB will have no choice but to be hawkish. Having been so proactive with injecting liquidity in the midst of the credit crunch in August, the ECB may be proactive again with combating inflation. They need a strong Euro to offset the rising the cost of oil which is why we haven’t heard one word of complaint from Trichet even though the Euro has risen above 1.45. Economic data also continued to indicate that the impact of a strong currency on the German economy has been limited as industrial production was much stronger than expected in September. An interest rate hike by the ECB or hawkish comments tomorrow could exacerbate the strength in Euro. We believe that the ECB could say that “strong vigilance” is needed towards inflation, which would signal that rates would be raised in the very near future.

USD/JPY Falls to Weakest Level in Over a Month
With the Dow down 360 points today, Japanese yen crosses suffered serious losses. The biggest loser was CAD/JPY which dropped 2.5 percent. For the past two weeks, USD/JPY had been trading in a range but today it broke to the downside and is closing in on its 2-month low. At this point we expect further weakness since the strong move in the Dow will likely lead to follow-through selling of Asian and European equities. The liquidation of the Japanese yen crosses has been primarily driven by the liquidation out of USD/JPY. The reason why China’s comments have such a profound impact on the Japanese currency is because the yen tends to be a proxy for Asian currency strength and weakness. Tonight we have machine tool orders and money supply, neither of which will be particularly market-moving.

British Pound Takes Out 2.10
Over the past few days we have been talking about the potential of the GBP/USD rising to 2.10; and today not only has that price level been achieved, but the GBP/USD traded as high as 2.1073 at the beginning of the US trading session. The only piece of UK economic data released was the shop price index for the month of October. Like the Eurozone, the UK also faces inflationary pressures. The Bank of England will be announcing their interest rate decision tomorrow. We expect this to be a nonevent since the BoE will not be altering interest rates and when no change is made, they typically do not release a statement.

Canadian Dollar Sees Sharp Reversal: Is this the Bottom?
Even though the US dollar weakened significantly, the Australian, New Zealand and Canadian dollars all ended lower against the greenback. This move represents a sharp intraday reversal for 2 of these pairs which had at one point hit new multi-decade highs intraday. According to Antonio Sousa, the FXCM SSI indicates that for the first time since September, our most speculative traders did not add to their long USD/CAD positions hoping for the bottom. In a trending market, this subset of investors frequently gets caught on the wrong side of the trade. With today’s fresh record low, open positions plummeted and longs fell 19 percent since yesterday. When traders finally throw in the towel and give up trying to pick a bottom, that is frequently THE actual bottom, so 0.9059 could be the bottom in USD/CAD.

Kathy Lien is the Chief Currency Strategist at FXCM.