Dollar – Will the Fed Cut Again?
Bewildering. That’s about the only way to describe the price action in currencies this week as EUR/USD first plunged to 1.4360 only to rise in a near vertical fashion to 1.4770 by early European trade on Friday. For the week the dollar gave back 100 points, but the placid end result hid the heart-stopping price action in between. What happened? Global equity markets cratered over the MLK holiday. Thus, confronted with a very real possibility of -1000 Dow day, the Fed decided to do something extraordinary – an inter-meeting 75bp cut. The amplitude of easing was stunning. Only once in the past 25 years has the Fed cut by as much as 75bp and that was during the 1980’s when interest rates were at double digit levels.

In the near term the move assuaged the markets as equities stabilized and Dow put in a 600-point recovery on Wednesday. The turnaround in equities was a dose of confidence for the currency markets and carry trades zoomed to the upside. EUR/JPY rose four big figures in one day taking the EUR/USD along for a ride. But, like a junkie looking for the next high, the markets want more and next week all eyes will be on the FOMC meeting as equities seek further easing.

At the height of the panic last Tuesday, futures were pricing in another 50bp cut on January 30. Since then, cooler heads have prevailed and expectations have been ratcheted down to 25bp. We believe the consensus view is correct and the Fed will cut 25bp at most preferring to save its ammunition for another day. Nevertheless, if the Fed lowers 25bp that will mean the US rates have declined by 100bp in just one month – a factor that should weigh on the greenback over the long run. On the positive side however, is an expected jump in NFP numbers. If that data surprises to the upside, some of the doom and gloom talk may ease providing the greenback with a lift as recessionary fears recede for the time being.

Euro – IFO Provides Support
Aside from the rising stock markets and the return of risk appetite, the euro received a major boost from better than expected IFO numbers which printed at 103.4 versus 102.3. As we noted on Thursday, “Tonight’s IFO results put an end to any notion of a near-term rate cut from Mr. Trichet and company. For the time being the region’s economy continues to expand at a moderate pace allowing ECB authorities to maintain their hawkish posture.”

That hawkish posture may soon change, however, if consumer sentiment in the region does not improve. The GFK polling of German consumers recorded its lowest reading in two years while in Italy Retail Sales actually contracted -0.3% on a month over month basis. The negative effects of the global credit crunch are slowly seeping into the real economy in the Euro-zone and should turbulence persist, consumer demand may weaken significantly, undermining ECB’s hawkish outlook. For now however, European monetary authorities continue to err on the side of price stability maintaining a restrictive policy.

Next week, the trade in the EUR/USD will be driven almost exclusively by US event risk as FOMC and NFPs loom large on the horizon. In addition, equity market turbulence may still be a factor leaving the pair very vulnerable to more seesaw price action. In the near term the dollar may gain next week if the Fed cuts only 25bp or if risk aversion comes back to the market. But, in the long term the euro – which for the first time since 2002 pays more interest than the dollar – continues to have the upper hand.

Japanese Yen’s Next Move Dependent on Equities, Fed Decision
The Japanese yen traded choppily across the majors last week as the markets were thrown into turmoil amidst major volatility in equities. Indeed, Asian stock markets plunged early in the week, and with Wall Street closed on Monday, there were well-warranted fears that indexes like the Dow and S&P 500 would plummet upon Tuesday’s open. Fear continued to climb as futures for those indexes were down more than 5 percent during the Tokyo and London trading sessions, but the markets breathed a sigh of relief when the Federal Reserve came to the rescue with an emergency 75bp rate cut. However, it was revealed later in the week that Bernanke & Co. were not aware that on Monday, Société Générale unwound the positions of rogue trader Jérôme Kerviel, which is likely to have contributed to the sharp drops in European shares that added to the broad bearish market sentiment. So the question is: did the Federal Reserve flinch in the face of a stock-market sell-off and use monetary policy to quiet the cries of Wall Street? This is what markets should be wondering as they try to speculate what the Federal Reserve will do this Tuesday.

That said, with risk aversion trends and the status of the US Dollar remaining the primary driver of USD/JPY – rather than Japanese fundamentals – the Federal Reserve’s rate decision on Tuesday and the reaction of global stock markets remain the key event risk for the pair. If the Fed’s rate cut last week was indeed a panic response and an ill-advised decision, the central bank may not see the need to reduce rates again, even though fed fund futures are pricing in at least a cut to 3.25 percent, and 70 percent chance of a decrease to 3.00 percent. In this case, risk aversion and flight-to-safety may emerge again, sending global equities and the Japanese yen pairs spiraling lower. On the other hand, as Technical Strategist Jamie Saettele pointed out in Friday's Daily Technical Report, USD/JPY may “exceed 107.92 and test resistance in the mid 108’s” in the near term before moving on to another bearish leg. Nevertheless, it will be important to look at Japanese economic data as well, as the figures may guide future monetary policy decisions by the Bank of Japan. Retail sales and labor market conditions are anticipated to deteriorate, as tepid wage growth and falling disposable income (as a result of energy and food price gains) do little to boost already-weak consumption in the country. Meanwhile, industrial production is forecasted to rebound in December on the back of Asian demand for Japanese goods, but with global growth expected to slow in 2008, exporters are likely to reduce output in coming months.

British Pound Breaks Downtrend as BoE Minutes Dampen Further Cuts
The British pound saw a significant bullish turn last week against the US dollar and most of its more liquid crosses despite mixed fundamentals. For the benchmark GBP/USD, the pair opened the period by sustaining its steep downtrend. On Monday, like many other risk-related assets across the globe, the sterling was under pressure as traders looked to dump their more precarious investments, including the high-yielding currencies. This broad wave of risk aversion was triggered by the biggest drop in global stocks in over 5 years. While this move was originally believed to be a mere change in sentiment, the market later learned that a massive unwinding of positions from Societe General, who uncovered a massive book of losing positions under one trader, may have triggered the panic selling. However, after this sharp move, the market slowly but surely started to buy back the sterling and other high yielders after the Fed delivered an emergency rate cut that calmed fears that the world’s largest economy was heading for a recession and would take the rest of the globe with it.

With these sentiment trends in mind, the economic calendar would also play its part in guiding the pound last week. Before the London trading session opened on Monday, the leading Rightmove housing price index confirmed the decade long boom was over. The average home price fell for the third consecutive month, while annual inflation marked its biggest drop since December of 2005. Officials at Rightmove foresaw further declines for the residential market unless the BoE cuts rates further. However, if the minutes from the last MPC meeting are any guide, a cut may not be close at hand. An 8-1 vote to keep rate unchanged at 5.50 percent was delivered as policy officials forecasted inflation possibly breeching 3.0 percent, even though GDP could slow “possibly quite sharply.” And, while the faltering in the domestic housing market and quickly cooling US economy threatened to stunt UK growth in the future, the advanced reading of fourth quarter growth suggested the economy wasn’t struggling just yet. According to the government’s data, annualized expansion slowed to a 2.9 percent clip, the slowest in nearly a year. However, most of the major sectors were still reporting reasonable growth.

Ultimately, though, with economic and sentiment trends vying for control of the pound, the GPB/USD would finally break an eight-week falling trend channel in a move through 1.98. Whether or not this trend can be sustained, though, will fall once again to scheduled and unscheduled event risk this week. The economic docket won’t have the same top tier market movers as last week, but a few indicators will certainly impact fundamental flows: the Nationwide housing inflation report will add insight to the Rightmove figure, the GfK consumer sentiment survey will offer a forecast for spending trends and a factory PMI number will take the temperature of the business sector. Looking beyond the calendar, risk trends will almost certainly be a factor for the high-yielding pound again as all eyes will be on the FOMC’s rate decision and US fourth quarter growth numbers to see if the US will usher in a global economic slowdown and rate easing policy.

Swiss Franc Outlook Cloudy on Economy, Carry Trade
The Swiss Franc began the week significantly stronger against major currency counterparts, but a later reversal in the Dow Jones Industrial Average and other major equity indices forced a commensurate pullback in the risk-sensitive currency. Indeed, the tremendous tumbles in global stock markets sent the low-yielding CHF near record-highs against the US dollar and 13-month highs against the euro. Yet the Swissie turned on a dime when a surprise 75 basis point interest rate cut from the US Federal Reserve sent major risky asset classes significantly higher in its wake. Domestic economic developments took a backseat to the happenings in global financial markets, and we saw relatively little reaction to modestly disappointing inflation and retail sales figures. According to the Swiss Federal Statistical Office, Producer and Import Prices unexpectedly fell through December on falling raw materials costs. Given forecasts of a 0.2 percent monthly gain, the result certainly proved disappointing to those who believe that higher import prices will drive the Swiss National Bank to raise rates through 2008. Yet one month does not make a trend, and markets will clearly wait until the release of later inflation numbers to shift forecasts on domestic yields. A subsequent Adjusted Retail Sales report likewise came below consensus forecasts, however, and consumption growth rates remained relatively low at 2.9 percent on a year-over-year basis. Though traders mostly ignored both retail sales and prices reports, it remains clear that continued disappointments in economic data could sink the recently high-flying European currency.

The coming week will help solidify Swiss interest rate forecasts, as closely followed KOF Leading Indicator and SVME PMI reports will provide a forward-looking peak at the robustness of the domestic economy. Current consensus forecasts show that analysts believe the KOF Leading Indicator will fall to 9-month lows through January—hardly a bullish assessment on overall growth prospects. Subsequent SVME-PMI figures are forecast to show a similar deceleration in overall expansion; an in-line result would leave the figure at its lowest levels since September. It will be important to watch developments in both KOF and SVME reports, and any significant disappointments would only further temper bullishness for the domestic currency. Yet Swissie price action will likewise depend on developments in broader financial markets. Given the low-yielders strongly negative correlation with major risky asset classes, any further Dow Jones Industrials rebound could sink the CHF against higher-yielding counterparts. Of course, the opposite is likewise true; a strongly negative week for the Dow and other stock markets could leave the Franc at significant heights against the euro and other risk-sensitive currencies.

Canadian Dollar Gains Despite Rate Cut by the Bank of Canada
The Canadian dollar strengthened against the US dollar over the course of the week, despite a rate cut by the Bank of Canada, as interest rate differentials continue to benefit the Loonie. Indeed, the possible implications of a 25bp rate reduction to 4.00 percent - lowest level since April of 2006 - by the Canadian central bank was offset by an unexpected emergency 75bp rate cut by the Federal Reserve. Nevertheless, there is potential for Canadian dollar weakness in the future, judging by the policy statement that accompanied the BOC rate announcement. While the outlook for growth was still relatively upbeat, as the bank said it expected domestic demand to “remain strong,” the group lowered its outlook for growth in 2008, saying it was “significantly weaker” than its October projection given the negative impact of the rapid appreciation of the Canadian currency on export sector activity. On the inflation front, the BOC forecasted core CPI to fall below 1.5 percent by mid-year - which appears entirely possible after the bank’s inflation measure surprisingly dipped to 1.5 percent in December – and with the BOC’s inflation target still well above at 2 percent – the statement said that further “stimulus” would likely be needed in the “near term.”

Looking ahead to this week, the fate of USD/CAD will likely depend more upon the status of the greenback given the major event risk looming in the US. Meanwhile, Canadian economic data may not prove to be extremely market-moving though they could contribute to Loonie weakness. The orders component of the Business Conditions index is anticipated to drop to a one year low of -6.5, as the combination of an economic slowdown in the US and a stronger Canadian currency prove to be a major hindrance for manufacturers. Meanwhile, November GDP figures are forecasted to reflect tepid growth, though the Q4 GDP reports (which will not be released until early March) will be a far better gauge of the status of the Canadian economy. Regarding USD/CAD, according to Technical Strategist Jamie Saettele’s Daily Technical Report on Friday, “potential resistance is at 1.0128,” and a failure to break above this level may find the pair falling back below 1.0012. Nevertheless, traders should keep an eye on broad US Dollar trends, as they may dictate the next move for USD/CAD.

Australian Inflation Elevates the Risk of an RBA Rate Hike
Like the rest of the currency markets high yielders, the Australian dollar displayed dramatic volatility last week as the financial markets oscillated between risk aversion and appetite. The dollar opened the period by picking up where it left off the previous week in a steady decline. With an unexpectedly heavy selloff in global equities, investors unwound their carry trades to avoid a flight from risk that was jumping across asset boarders. Then on Tuesday, just as quickly as the Aussie dollar rolled over into its selloff, the unit turned on a spike low just above 0.8500 after the Federal Reserve looked to secure confidence in the markets by issuing an emergency rate cut.

While these sentiment trends certainly had their way with Aussie dollar price action, economic data from the Australian calendar certainly helped to sustain the currency’s rebound with bullish readings from both growth and inflation readings. The fourth quarter producer price inflation gauge was a buildup to the more closely watched consumer-level reading due later in the week. According to the government’s statistics, factory-level inflation rose at a less than expected 0.6 percent over the final months of the year. This still left the annual figure at a yearly high 2.8 percent clip. It was Wednesday’s CPI numbers that really caught the market attention though. Headline price pressures accelerated as expected to a 3.0 percent pace – right at the top of the RBA’s tolerance band. More surprising was the core reading (excluding the 14 percent and 6.9 percent drop in fresh fruit and vegetable prices, respectively), which surged to a 16-year high 3.8 percent. Before the CPI numbers, the market was pricing in a 22 percent chance of a rate hike on February 5. Immediately after, that probability jumped to 47 percent. However, the RBA may not be able to hike on inflation alone, as financial markets have been racked recently and growth trends may cool. However, these forecasts were not being confirmed by the November leading economic indicators reports over the week. The Westpac index rose for sixth month to its highest reading in over four and a half years, suggesting the engines are still firing.

In the coming week, the economic calendar’s fundamental influence over the Aussie dollar will certainly wane. There are a few second tier market movers on the roster. Private sector credit and HIA new home sales will measure consumer well and spending habits through December. The NAB business sentiment survey for the same period will reflect the impact that higher lending costs, volatility in financial markets and a potential cooling in global growth has had on activity. However, these numbers aside, the true event risk will lie outside of the calendar. The FOMC’s rate decision may act as a compass for RBA policy officials as they gauge the Fed’s outlook on global growth trends through monetary policy. Another sharp cut from Bernanke may put Governor Stevens in a wait-and-see mode.

New Zealand Dollar Improves on RBNZ Rate Outlook
Tremendous volatility in global equity markets made for similarly dramatic moves in the New Zealand dollar, with an early-week Kiwi tumble making way for an impressive end-of-week reversal. Indeed, the New Zealand dollar seemed destined to finish the week sharply lower against its US namesake, but markets clearly had other things in mind in forcing a near-400 point reversal through Friday’s close. A recovery in the Dow Jones Industrial Average and other major indices clearly led the Kiwi reversal, while surprisingly hawkish rhetoric from the Reserve Bank of New Zealand likewise bolstered the attractiveness of the domestic currency.

The central bank left its record-high short-term interest rate target unchanged at 8.25 percent, while subsequent commentary made it relatively clear that rates would remain stable through the medium term. Markets subsequently tempered expectations for future RBNZ rate cuts, and the New Zealand dollar stood to gain from the improved outlook for domestic yields. Yet a later speech by Governor Bollard underlined major risks to New Zealand’s economic prospects, and markets remain mindful that a sudden slowdown in NZ growth could dull the luster on the high-yielding New Zealand dollar. Currently fragile financial market conditions arguably favor further kiwi losses through short-term currency trading, but it will be important to watch for any sudden shifts in global risk sentiment and the performance of major equity indices.

Foreseeable event risk for the New Zealand dollar will be relatively limited in the week ahead, but any sizeable surprises in upcoming Building Permits or Trade Balance reports could easily force sharp intraday volatility across NZD pairs. Analysts expect Tuesday’s Building Permits report to show further weakness in housing starts, and Kiwi risks are arguably weighed to the downside ahead of the report. Given a clearly disappointing result, traders will likely pull back optimistic forecasts for the future of domestic interest rates—removing a key pillar of support for the domestic currency. Otherwise, traders will watch for any surprising results in Wednesday’s Trade Balance release. Strong demand for agricultural exports will likely force a significant narrowing of New Zealand’s trade deficit for the month of December, but any disappointments could easily force NZD drops.

Boris Schlossberg is a Senior Currency Strategist at FXCM.