Does the Federal Reserve Have a Plan B?
The Federal Reserve has cut interest rates, bailed out a US bank for the very first time since the Depression and announced that they are willing to swap their safe US Treasuries for risky and dubious mortgage backed securities. Despite their efforts however, the US economy is still in trouble and liquidity in the money markets remain a problem, which leads everyone to wonder whether the Federal Reserve has a Plan B. According to the UK Telegraph, the Federal Reserve is “eyeing the Nordic Style Nationalization of US banks” as a temporary solution to the US financial crisis. Between 1991 and 1993, Norway, Sweden and Finland nationalized several institutions and their efforts have been touted as one of the most successful central bank rescues in recent history. Nationalization will not be taken favorably by the currency market, especially when it hits the newswires. Remember when the Bank of England announced that they were nationalizing Northern Rock back in April? The British pound fell 300 pips in 3 days. With interest rates already at 2.25%, how much further could the Federal Reserve cut interest rates? The low point in the past decade has been 1 percent, but the continual rise in the price of consumer staples such as rice, will force the central bank to stop turning a blind eye to inflation. Short of printing money, the size of the Federal Reserve’s balance sheet will limit what they can do. Two weeks ago, the Fed committed to swapping 60% ($420 billion) of its $700 billion balance sheet of safe and secure US Treasuries for risky and dubious mortgage backed securities. These extreme measures indicate one of two things (or both), which is that desperation is forcing the Federal Reserve to become more creative or they are running out of options.

With 2-year US Treasury yields falling to 1.5 percent, the market is still averse to risk and everyone knows that the worst is not behind us. Can the Federal Reserve print money? Yes, they can do whatever they want, but printing money also adds to inflationary pressures. With commodity prices already on the rise, Americans may not be able to handle even higher living costs. This week, Bernanke will be testifying before the Joint Economic Committee and it will be interesting to see if he brings up a Plan B. However before Wednesday, we are expecting the manufacturing ISM report. With Chicago PMI bouncing back, manufacturing ISM could also beat expectations.

Two Things That Can Drive the Euro to 1.60
The EUR/USD came within 10 pips of its record high this morning before reversing violently. The price action tells us that even though the market is very dollar bearish, it is not right time for a test of 1.60. Not only were today’s US economic numbers not very market moving, but they were actually dollar bullish. Yet, the EUR/USD ran from 1.5800 to 1.5896 almost immediately after the stronger Chicago PMI numbers were released. This morning’s Eurozone economic data also does not support a run for new highs. Even though the flash estimate for Eurozone consumer prices jumped from 3.2 to 3.5 percent, confidence on many levels deteriorated. German retail sales and employment numbers are due for release tomorrow and we expect these numbers to be Euro bearish. On Friday, we talked about the additional losses that German banks may be facing. This story was covered in several newspapers this past weekend, which may be adding to the pressure in the Euro. There are only 2 upcoming event risks that have the power to drive the EUR/USD to 1.60 this week; Federal Reserve Chairman Ben Bernanke’s speech on Wednesday and Friday’s non-farm payrolls report. Meanwhile the Swiss franc is stronger across the board despite the Swiss State Secretariat for Economic Affair’s downward revision to next year’s GDP forecasts.

British Pound Hits Record Lows Against Euro
The British pound extended its losses against the US dollar and hit a record low against the Euro on the back of zero consequential economic data. Although dollar strength could be partially blamed for the currency’s latest string of weakness, the main reason for the market’s bearishness is their concern that the UK could be in just as much trouble as the US. The only difference is the outlook for monetary policy. With the Federal Reserve, it is clear that they will continue to cut interest rates. Although the ECB is on the other side of the spectrum, they too have let the market know that interest rates will remain on hold for some time. The outlook for the BoE on the other hand is more convoluted. Even though economic data suggests that they should continue to lower interest rates, King warned this morning that it is crucial for them to prevent inflation from getting entrenched.

Reversal in Commodity Prices Drive Australian, New Zealand and Canadian Dollars Lower
The New Zealand dollar fell over 1 percent against the US dollar today as economic data was overwhelming weak with building permits, business confidence and money supply all falling short of expectations. Business confidence actually dropped to a 17 year low, suggesting that difficult times lie ahead for NZD economy. Australia also reported softer home sales and private sector credit while Canada was the only outlier with stronger growth in the month of January.

Yen Traders Look Forward to Tankan Report
The Japanese Yen weakened across the board today despite an improvement in industrial production and labor cash earnings. Earnings have been on the rise for the past 2 months which is very encouraging because weak wage growth has been the main reason why Japanese consumer spending is depressed. This evening we are expecting the Quarterly Tankan report. Business confidence should slip given the slowdown in the global growth and the recent appreciation of the Japanese Yen.

Kathy Lien is the Chief Currency Strategist at FXCM.