Why the Dollar May Rally
It has been a tough week for the US dollar. On Wednesday the greenback fell to a record low against the Swiss franc and now it ends the week not far from its 2.5 year low against the Japanese Yen. Negative retail sales, signs of a recession in the US manufacturing and housing sectors as well as bearish comments from Federal Reserve Chairman Ben Bernanke all provide strong reasons for the dollar’s weakness. Although we do not believe that the greenback has hit a bottom, we would not be surprised to see a bounce in the dollar this coming week. The US economic calendar is light with the only potentially market moving report being Thursday’s existing home sales data. Don’t forget that Monday is President’s Day which means that US markets are closed.

This gives traders the opportunity to seriously think about whether the Federal Reserve will really deliver a 75bp rate cut. Fed fund futures are now pricing in a 72 percent chance that the move will happen. The possibility of an inter-meeting rate cut is also being floated around, contributing to the dollar’s weakness. If the Federal Reserve fails to deliver, those who have short the dollar on this expectation will have to adjust their positions accordingly. We continue to stress that a 75bp rate cut is a severe move. The last time the Federal Reserve lowered interest rates by three quarters of a point was during Volcker’s term when he raised interest to as high as 20 percent to curb double digit inflation growth. Over the last 30 years, there has been 4 recessions in the US economy. An interesting question to ask is if the Federal Reserve has cut interest rates by more than 75bp to fight a recession? Yes. In the past 3 decades, there have been times when the Fed cut rates by 200bp in a single meeting, but interest rates at the time was 18 percent. Since US interest rates are now at 4.25 percent, a 75bp rate cut on a percentage basis would be far more significant than a 200bp cut when rates were at 18 percent.

Euro: Analysts Turning Bearish?
Today we received a call from Bloomberg News asking for our comments on the outlook for the Euro. The reporter on the phone said that many analysts are turning bearish and asked how we felt. It was actually quite surprising to hear that other analysts have actually shifted their stance because if we learned anything this past week, it is that the US economy is in worse shape than many people may have initially thought.

We are still bullish Euros in medium term because European economic data has held steady for the most part and with the exception of Mersch, ECB members remain hawkish. Trichet will be speaking on many occasions next week and we expect him to reiterate the central bank’s threat to do everything in their power to contain prevent second round effects.

However as we indicated in our Dollar commentary, even though we are medium term bearish dollars and bullish Euros, there is a strong chance for a dollar rally in the coming week. From a Eurozone perspective, we have producer prices, PMI numbers and the German IFO report due for release. We actually expect all of these numbers to be Euro bearish because the recent rate hike should drive down inflation and business confidence. Switzerland will be reporting producer prices and retail sales. Although these numbers are important, recent Swiss data has not been market moving.

Only Two Things Can Help the British Pound
Records have been made in the British pound crosses this week, leading many traders to wonder when the pain will end. Despite a stronger labor market report for the month of December, retail sales for the same period fell the most since January 2007. With the housing market deteriorating and consumer spending contracting, the Bank of England will have no choice but to cut interest rates in February. We still believe that they passed up a golden opportunity to cut interest rates earlier this month and rebuild their credibility but there is no point dwelling on missed opportunities. Now that oil prices have retreated and the economy has worsened, another quarter point easing is inevitable. There are only two things that can help the British pound at this point; a wave of risk appetite that takes all carry trades including the pound crosses higher or less dovish BoE minutes due on Wednesday.

What’s in Store for the Australian, New Zealand and Canadian Dollars
The Australian, New Zealand and Canadian dollars weakened significantly this week despite stronger Australian and New Zealand economic data. This is partially due to the overall drop in commodity prices and largely due to the massive liquidation out of carry trades. In the week ahead, the Australian, New Zealand and Canadian dollars will be in play with the central banks of Canada (BoC) and New Zealand (RBNZ) making interest rate decisions. The BoC is expected to cut interest rates by 25bp on the back of weak economic data, but strong inflation and retail sales numbers out of New Zealand will encourage the RBNZ to leave interest rates unchanged. Although there is no interest rate decision in Australia, they will be releasing inflation reports.

Dow Drops 500 Points this Week, Making it Difficult for Carry to Trades
US stocks performed horribly this week, making it extremely difficult for carry trades to rally. Whether we will see a recovery in carry trades in the coming week will continue to depend on the performance of the Dow. The sharp intraday recovery makes it difficult to accurately gage how stocks will open on Tuesday. The Bank of Japan will be meeting to decide on monetary policy next week. They have no flexibility to alter interest rates which means that the announcement should be a non-event.

Kathy Lien is the Chief Currency Strategist at FXCM.