Stocks Drop 237 Points, Treasuries Fall to 3-Year Low, What Does it Mean for the Dollar?
The last two hours of trading in the US session has accounted for the majority of today’s volatility in the currency, stock and bond markets. The Dow plummeted 237 points, 10-Year US Treasury Bond yields fell to the lowest level since March 2004 and the US dollar fell to a fresh two year low against the Japanese Yen. This cohesive action price across the financial markets reflects serious concern about health of the financial sector and the growing possibility of a recession.

At this point, the US economy will live or die not by housing but by the level of consumer spending and the degree of leniency that creditors extend to their borrowers. Strong spending on the day after Thanksgiving (also known as Black Friday) has been completely discounted by traders and analysts who are worried that the demand will not continue. Consumers responded well to the sharp discounting but retailers may have to offer similar discounts to keep consumers spending. In today’s financial papers, next to the articles about retailers ringing in strong sales are articles about consumers debating between holiday shopping and their mortgage payment. Ultimately this choice is a lose-lose situation for the US economy.

In the financial sector, fresh layoffs have been announced by Citigroup raising fears that many banks will continue to report losses. Federal Reserve Chairman Ben Bernanke is scheduled to speak at the end of this week. If he touches on monetary policy or the economy, the chances are that he will be more bearish than bullish. There are a lot of US economic data due for release this week and our bias is in favor of stronger numbers. The main reason for this is because most of the reports are related to sectors that benefit from dollar weakness. For example, durable goods and Chicago PMI are due for release, both of which reflect domestic and external demand. Durable goods should show Boeing’s outperformance over Airbus who complained loudly about the dollar’s weakness being “life-threatening” last week. As for new and existing home sales, even though we continue to believe that the housing market will be depressed, recent reports of pending home sales and builder confidence suggest that it may be deteriorating at a much slower pace than previous months. Although the weakness of the dollar should attract foreign investment into the US housing market, any dollar rally will not be easy. The markets believe that the chances for a recession are growing and strong US data will be needed to convince them otherwise.

Euro: Ready for a Breakout
The Euro is trading not far from its record highs and this consolidative price action tells us one thing, which is that the currency is ready for a breakout. Judging from the price action of the currency as well as the sentiment of the overall financial markets, the odds are definitely more in favor of an upside breakout. We continue to believe from a fundamental and technical perspective that we will see 1.50 before we see 1.46 in the EUR/USD. However beyond that the call becomes much more difficult. When the EURUSD came close to touching 1.50 on Friday, ECB officials began to get worried. Central Bank President Trichet said that he was opposed to brutal FX moves even though he did not specifically describe the Euro’s move as brutal.
This morning we had a barrage of additional ECB speak. For the most part, the central bankers felt that inflation will continue to rise in the coming year and growth will slow. Their perspective on the Euro is probably best described by Wellink who said that the currency’s recent rise is not an “immediate concern,” but a further rise will be “worrying.” This suggests that a breach of 1.50 may force them to act either verbally or physically.

British Pound: Licking Its Wounds
The British pound licked its wounds today after difficult trading over the past few weeks. The UK economic calendar is light with no numbers due for release until Thursday. This suggests that pound strength or weakness will be largely contingent about the market’s demand for risk as well as Eurozone and US economic data. Bank of England monetary policy member Bean left us some food for thought this morning when he said that the current level of inflation may necessitate tighter monetary policy. The market is currently pricing in 75bp of easing by the middle of next year. If we hear similar comments from the BoE again, then a repricing of expectations may be warranted.

Risk Aversion Sends Australian, New Zealand and Canadian Dollars Lower
The Australian, New Zealand and Canadian dollars continue to fluctuate within wide trading ranges with one day of gains being followed by another day of losses. Today, we are trading near the bottom of the range which means that the currency pairs will either break down against the US dollar and suffer sharp losses or revert back to their trading existing ranges. Commodity prices are basically unchanged today but they too are trading near pivotal levels and as a result we would not be surprised to see the trading ranges broken this week.

Japanese Yen Crosses Tumble on Equity Market Weakness
With the Dow tumbling over 200 points, it would be surprising if carry trades actually managed to stay in positive territory. All of the crosses are down sharply and USDJPY is now trading at a fresh 2 year low against the US dollar. News has surfaced that China may be planning to invest some of their FX reserves into Japanese stocks. Supposedly their request was denied but when the CIC was contacted later, they said that no decision has been made yet. The bottom line is that China is actively looking for ways to diversify their reserves which will be positive for the currencies of countries outside of the US that they do a lot of trade with China such as Japan.

Kathy Lien is the Chief Currency Strategist at FXCM.