Dow Drops 200 Points, Dollar Strengthens and Carry Trades Resume Weakness
The US dollar is up across the board but that strength is more of a reflection of rising risk aversion than a rosier outlook for the US economy. Stocks are down over 200 points, bond yields have plummeted, carry trades resumed their weakness and gold prices are off one percent. This cohesive price action reflects a market that believes the Federal Reserve will lower interest rates by another 25bp next month. In fact, rate cut expectations have increased to 100 percent today from 90 percent on Friday. Investors continue to be worried about the housing market and the banking sector after Goldman Sachs downgraded Citigroup stock to sell. The 2 year US swap spread also jumped to levels last seen in 1989, leading us to wonder if the latest rise in risk aversion will be as bad the one in August. The rise in the swap spread indicates that concerns about credit and funding have returned. Although we still have over 3 weeks before the next FOMC meeting, if rate cut expectations stay at present levels, the Federal Reserve may have no choice but to bow to market pressures by lowering interest rates once again. They may actually need to do so if the holiday shopping season proves to be as tough as some analysts expect. The NAHB housing market index remained unchanged for the month of November which is the first time in 9 months that the index did not deteriorate. It is still premature to assume that the housing market has bottomed. Housing starts and building permits are due for release tomorrow, unless we have a big rebound, the sector remains vulnerable to further losses. Meanwhile we are also expecting the minutes from the October 31st monetary policy meeting. It will be interesting to see if the Fed’s decision to lower rates was a reluctant one. Given Bernanke’s greater concern about growth than inflation last week, hawkish minutes may actually not be market moving.

Euro: Will We See Another Thanksgiving Week Breakout?
For the past week, the trading range of the Euro has slowly decreased, leading us to believe that we could see a breakout in the EURUSD over the next few trading days. Although Thanksgiving traditionally leads to quiet trading, we do not rule out a big move since the drop in volatility has often times fueled major breakouts in the currency market. Last year for example, the EUR/USD broke out of a week long consolidation and rose 100 points the day before Thanksgiving. On Thanksgiving Day there was no major price action but on the Friday following Thanksgiving, the EURUSD extended its gains by another 150 pips. Based upon the EURUSD’s recent price action, the odds are certainly in favor of greater volatility this week. ECB President Trichet and member Liebscher were on the wires talking about growth and inflation risks. Both seem to agree that even though slower GDP growth is a possibility, in the medium term the risk to price stability is still to the upside. German producer prices are due for release tomorrow and we expect growing inflationary pressures. Switzerland will be releasing their October trade balance numbers. Even though the Swiss franc has plummeted against the Euro this month, in October it actually sold off which is why we expect a stronger trade surplus. USDCHF continued to weaken and is within 50 pips of its 1995 low.

British Pound: Still Weak But Losses are Becoming Limited
Even though the British pound sold off against every major currency today with the exception of the Australian dollar, the losses against the US dollar are becoming limited. We believe that a bounce at this point is very likely especially given the spike bottom on Friday, but any bounce should be seen as an opportunity to add to short positions because UK fundamentals are deteriorating by the day. According to Rightmove, the average asking price of UK homes fell 0.7 percent in November. Their commercial director recommends that ``If you have to sell, then seriously consider dropping your price and taking an offer now rather than holding out.” This is certainly not a favorable market for the UK home owner and we expect these conditions to be reflected in the overall economy in the months to come. Money supply, mortgage approvals and the CBI industrial trends survey are due for release tomorrow. Inflation could still be high, but mortgage approvals and CBI industrial trends could deteriorate.

Canadian, Australian, New Zealand Dollars All Face Sharp Losses
The Canadian, Australian and New Zealand are all significantly weaker today despite mixed economic data. The selloff was primarily due to equity market weakness and rising risk aversion. The Canadian dollar was the worst hit as a sharp rise in wholesale sales failed to offset the fifth monthly decline in foreign investment. Comments from Bank of Canada Governor Dodge this weekend also pressured the loonie. He said that risks to global growth have increased over the past month and he will take this into account when they meet to decide interest rates next month. To some traders, these comments suggest that an interest rate cut may be likely. We will need to see CPI tomorrow to be sure that the strong Canadian dollar has kept inflation under control.

Carry Trades Hit by Rising Risk Aversion
News that China will be curbing bank loans sent stock markets around the world tumbling. The Dow followed suit at the US market open and ended the day down over 200 points. Unsurprisingly, this rise in risk aversion has sent carry trades tumbling. USDJPY for example is close to making a new year to date low while the other yen crosses will soon make two month lows. There is no major Japanese data on the calendar this week which means that further strength or weakness will be almost exclusively dependent upon equity market performance.

Kathy Lien is the Chief Currency Strategist at FXCM.