Fears of a Recession Drives Renewed Dollar Weakness
The US dollar has resumed its slide as traders give in to the Fed’s cautiousness. With Wall Street and Main Street both feeling the pain of slower growth and a depressed housing market, Bernanke warned that there could be a contraction in the US economy in the first half of the year. Although the Fed Chairman stopped short of admitting that the US economy is already recession most Americans are already acting like it. The NY Times for example has a story today about making the most out of your microwave. Interestingly enough, according to Fed Fund futures, expectations for a 25bp rate cut at the end of the month has increased to 90 percent. This is partially due to the rebound in the ADP employment report, which is signaling a stronger non-farm payrolls number for Friday. We are skeptical of the accuracy of this report given the fact that ADP has overestimated private sector payrolls growth for the last 6 months by an average of 72k jobs. Unless we see an improvement in the employment component of service sector ISM tomorrow, we continue to believe that the pace of job growth will worsen in the coming months. Challenger Gray and Christmas reported a 9.4 percent increase in layoffs last month compared to a year ago. This is in line with the recent layoffs that have been announced by Wall Street banks. On inflation, Bernanke said that even though it is a concern, inflation should moderate, which means that for the time being boosting growth is their top priority. Looking ahead, non-farm payrolls will be critical in determining how many more rate cuts we will see from the Federal Reserve. In the beginning of the year, the majority of the market believed that the central bank would stop cutting interest rates at 2.00 percent. Now that we are 25bp away from that level, figuring out how much further the Federal Reserve could ease interest rates should be the market’s main focus.

British Pound: Watch Out for More Housing Market Problems
Last week, we indicated that the British pound could break 2.0 if disaster hits UK mortgage lenders. The currency is trading below 2.0 against the dollar, but thankfully there has been no disaster. However, trouble is still brewing for mortgage lenders or banks that have mortgage lending divisions and things are only expected to get worse. First Direct, which is apart of HSBC announced today that they will be withdrawing all of the mortgages to any homeowners who are not existing customers. Standard & Poor’s is also reporting that Lehman Brother’s has stopped writing mortgages to 2 of their UK units. Halifax, the UK’s biggest mortgage lender is expected to follow suit within days. Being forced to turn away business because you have too many customers should be perceived as a good thing, but unfortunately in the world of mortgage lending in UK, the only reason why First Direct and Halifax are being flooded with new applications is because other lenders like Nationwide gave taken measures to increase the interest rate on loans or withdraw their mortgage lending products completely. If everyone stops providing new mortgages, it could cause the entire UK housing market to freeze up. Meanwhile, this morning’s UK economic data was mixed with construction sector PMI contracting for the first time in six years and net consumer credit hitting a five year high. Service sector PMI is due for release tomorrow and unlike the manufacturing sector, we expect activity in the service sector to slow.

Euro Recovers After Bernanke Comments
It has been a volatile day for the EUR/USD. The currency first rallied on the stronger inflation report, then slipped following the release of the dollar positive ADP report, and resumed its rally after Bernanke’s comments. Inflation is hot which is hardly a surprise given the rise in food and energy prices. We had previously indicated that the Euro’s strength could reverse if German banks begin hemorrhaging losses. Yesterday Deutsche Bank reported additional write downs and today WestLB announced $2.5 billion in losses. Yet German growth is only expected to slow modestly according to the German DIW economic institute which downgraded its growth forecasts by only 0.1 percent to 2.0 percent. Eurozone retail sales are due for release tomorrow. The steep drop in German retail sales suggest that we could see a similar decline in consumer spending for the entire region.

Australian, New Zealand and Canadian Dollars Rebound
The New Zealand Dollar, Australian Dollar and the Canadian Dollar, rebounded against the mighty greenback thanks to a recovery in commodity prices. Traders did not have much to key off of today, but the next 24 hours could prove to be much more eventful, with Australia releasing their service sector PMI figure which is anticipated to decline, as high interest rats would likely result in falling business demand. New Zealand is set to release the ANZ Commodity prices, which should increase as demand for soft commodities continue to rise. Although Canada has no releases tomorrow, investors are eagerly anticipating for the end of the week, when some major market moving data are set to release, starting with the unemployment rate and ending with Ivey Purchasing Managers Index.

Japanese Yen Extends Losses on Little Economic Data
All of the Yen crosses have rebounded today despite little Japanese economic data. Compared to a few weeks ago, risk appetite has certainly improved. Gold prices are well off its highs, but as we all know, risk appetite can change on a dime. Non-farm payrolls will be critical in determining whether we see a more meaningful rally in carry trades. Although we could still see a further bounce, longer term trend for USD/JPY and other the Yen crosses, is still down.

Kathy Lien is the Chief Currency Strategist at FXCM.