Dollar Takes a Nosedive After Federal Reserve Lowers Growth Forecast
With the US economy deteriorating, we have been very suspicious of the recent dollar rally. The rebound has been primarily attributed to the hope for a shallow downturn and a swift recovery, but today’s comments from Federal Reserve Chairman Ben Bernanke suggests otherwise. In his testimony to Congress, Bernanke warned about the downside risks to growth and despite the recent recovery in consumer spending, he expressed concern that the weakness of the labor market will pressure consumer spending going forward. As a result, the Federal Reserve will be lowering their projections for US growth next week. Back in November, they projected growth to be between 1.8 to 2.5 percent in 2008. To put these numbers into perspective, the market expects the Eurozone to grow by 1.8 percent this year as well. The US central bank stands ready to act in a timely manner” which means that they plan on cutting interest rates further. Before getting too excited, however, Bernanke also stressed that monetary policy works with a lag. He may be telling us that the Fed plans on slowing down because the economy needs time to absorb the recent rate cuts. Easing interest rates too sharply over a short period of time could backfire, by driving up inflation pressures and making it difficult to fight inflation if the economy continues to slow. Bernanke’s comments completely overshadowed the better-than-expected trade balance. The deficit fell from $63.1 billion to $58.8 billion as the weaker US dollar drives exports to a record high. This confirms the improvements that we have seen in the manufacturing sector. Tomorrow, we have a very long list of US data due for release including Import Prices, the Empire State Manufacturing Survey, the Treasury International Capital Flow report, Industrial Production and the University of Michigan Consumer Confidence report. Aside from confidence, we expect most of the numbers to be dollar bullish.

Euro Recovery Halted by Weaker Industrial Production
The Federal Reserve’s continued for concern about growth and the European Central Banks “mixed messages” has helped the Euro rally another 100 pips. According to the ECB’s February monthly bulletin, the central bank is really not sure how much of an impact the turmoil in the financial markets will have on the real economy. Quaden believes that slower growth could actually bring higher inflation while Gonzalez-Paramo sees no sign of a hard landing for the economy. This follows slightly better than expected fourth quarter GDP numbers. Growth slowed from 2.7 percent to 2.3 percent, which was slightly better than the market’s 2.2 percent forecast. Even though the Swiss franc is stronger across the board today, we had very bad Swiss data released this morning. The ZEW survey of analyst sentiment dropped to a record low while the unemployment rate jumped from 5.6 to 6.4 percent. UBS also reported $13.7B in write downs, the biggest loss by a bank in the fourth quarter. These numbers make a rate hike from the Swiss National Bank very unlikely. Swiss retail sales and the Eurozone trade balance are due for release tomorrow. Both numbers should reflect continued deterioration.

Bank of Japan Not Expected to Raise Interest Rates
The Dow dropped 175 points today, erasing nearly all of yesterday’s gains, but carry trades were mixed with some pairs like AUD/JPY and CHF/JPY gaining strength while others like GBP/JPY and USD/JPY selling off. This price action confirms our belief that the relationship between stocks and carry trades continues to break down even though we can still see some evidence of a mild correlation on an intraday basis. Japanese economic data was good with GDP rising from 0.4 to 0.9 percent in the fourth quarter and industrial production accelerating more than expected on an annualized basis. The Bank of Japan will be making their interest rate decision this evening. They are not expected to raise interest rates and the announcement should be a non-event for the Japanese yen.

Fifth Straight Day of Gains for the British Pound
Over the past five trading days, the British pound has rallied more than 300 pips. Stronger economic data and a hawkish Quarterly Inflation Report have reduced the chance that the Bank of England will ease interest rates aggressively. With inflation potentially breaching the government’s 3 percent limit, the BoE will be treading very carefully going forward. Unless they believe think that growth will slow materially, they will prefer to space out rate cuts in order to prevent inflation from getting out of hand. They are in the same situation as the Fed was last year where they are juggling persistent inflationary pressures with slowing growth. When data materially worsened and the credit crunch got out of hand, the Federal Reserve was forced to shift their focus away from inflation and onto growth, which was when they began cutting the discount rate and then the Fed funds rate.

Stronger Employment Data Drives Australian and New Zealand dollars Higher, Canada Suffers from Weak Trade Numbers
Not only did we have mixed price action in the commodity currencies once again, but also mixed economic data. The Australian and New Zealand dollars are up strongly today thanks to a sharp rise in Australian employment. With another 26k people added onto Australian payrolls, the unemployment rate fell to a 34-year low of 4.1 percent. The strength of the Australian economy and the tightness of the labor market explain why the Reserve Bank of Australia is the only major central bank that is continuing to raise interest rates. New Zealand reported a decline in business PMI and food prices, but these numbers are not very market moving. Instead, Kiwi traders are holding out for tonight’s retail sales report. Unlike the US, Canada’s trade surplus fell to a 9-year low, driving the Canadian dollar back towards parity.

Kathy Lien is the Chief Currency Strategist at FXCM.