Yesterday I said that the US dollar rally stemming from the Fannie Mae/Freddie Mac news was one to be leery of, and I still believe that to be the case. Indeed, according to COT forex positioning, the dollar is extremely overbought, suggesting we may be nearing a point where risk/reward warrants selling the greenback. We’ve seen some incredibly volatility in the currency, as the EUR/USD and GBP/USD pairs traded in more than 100 pip ranges. When it comes down to it though, the dollar still ended Tuesday up very slightly versus most of the majors (though it fell against the Japanese yen). Looking at the economic data on hand, US pending home sales fell 3.2 percent, as fewer Americans signed contracts to buy homes. Such a decline is not incredibly surprising, as demand for homes remains extremely weak given the US economic slowdown and more stringent lending standards. Meanwhile, wholesale inventories rocketed 1.4 percent in July while wholesales sales slipped 0.3 percent, suggesting that lackluster demand is leaving firms stuck with excess supplies. This does not bode well for this Friday’s advance retail sales release, especially given the continued deterioration in the US labor markets as indicated by last week’s US non-farm payrolls (NFPs) report.

Japanese Yen the Currency of Choice as Increase in Investor Confidence Proves Short-Lived

Monday’s surge in carry trades and the Japanese yen crosses subsequently saw a sharp reversal on Tuesday, as the increase in investor confidence following the US government’s seizure of Fannie Mae and Freddie Mac proved to be short-lived. Indeed, the DJIA – which gained 2.58 percent on Monday – plunged 2.43 percent on Tuesday, as 11,500 provided solid resistance. Meanwhile, the Japanese yen gained over 1 percent versus the Euro, British pound, and US dollar while jumping nearly 2 percent against the New Zealand dollar and 3 percent against the Australian dollar. As usual, Japanese fundamentals has little bearing on the currency, as the latest forex correlations report shows that carry trades and the DJIA have increasingly been moving in lockstep (though the correlation is not as high as it was in 2007). Going forward, the Japanese yen will continue to depend on the status of risk appetite in the market, and the evolution of the Fannie Mae/Freddie Mac story will certainly be one worth following.

British Pound Creeps Higher Despite Weak UK Data – Time to Buy?

The British pound climbed throughout the trading day following Monday’s test of 1.75 as COT forex positioning shows that the currency remains oversold and other indicators suggest potential GBP/USD buying opportunities. However, UK economic data remains overwhelmingly bearish, as UK industrial production failed to rise for the fifth consecutive month in July as mining, quarrying, oil, and gas output drops. The news comes on the tails over yesterday’s weaker-than-expected producer price numbers, which indicated that the Bank of England may be able to let their guard down sooner rather than later when it comes to inflation risks, especially since the central bank is already grappling with the issue of a rapidly deteriorating economy. This is much of the reason why Credit Suisse overnight index swaps are pricing in nearly 100bps worth of rate cuts by the Bank of England over the next 12 months, and if the official UK CPI numbers (due to be released on 9/16) signal that inflation is not accelerating as quickly as they expected, the central bank could start reducing interest rates before year-end. Thus, from a fundamental perspective, downside risks remain for the British pound, but from a technical perspective, I believe GBP/USD is due for a bounce from current levels.

Euro: Why the ECB Will Not Cut Rates Until 2009

The euro consolidated above 1.41 towards the end of the US trading session on Tuesday, as the US dollar remains relatively strong across the majors, but like the British pound, there are technical indications that EUR/USD could advance. Meanwhile, from a fundamental perspective, much of the EUR/USD decline has been due to speculation that the European Central Bank will cut rates while the Federal Reserve will hike. Last week, we saw the ECB leave rates unchanged at 4.25 percent, and as expected, ECB President Trichet remained hawkish on inflation and somewhat bearish on economic prospects, especially since ECB staff projections for growth were revised down for 2008 and 2009. Overall, though, ECB voting members remain focused on their primary mandate of price stability, suggesting the 25-50bps worth of cuts expected during the next 12 months will not occur until 2009. If this starts to become clear to the markets, the euro may finally have the fundamental impetus to recover.

Australian Dollar, New Zealand Dollar Hit Hard By Risk Aversion – Will the RBNZ Cut Rates?

The Australian dollar and New Zealand dollar both tumbled on Tuesday amidst a return to risk aversion, as carry trades throughout the financial markets experienced a sharp reversal. Economic news was limited, though Australian retail sales did edge slightly higher during the month of July. In a new monthly trend series, the government reported a 0.1 percent gain, matching the June reading. However, this report may now be less reliable since it takes into account a significantly smaller sample size, and will make it a bit more difficult for policy makers to gauge consumer spending, which accounts for approximately 60 percent of economic growth. The biggest piece of event risk by far, though, will be the Reserve Bank of New Zealand’s rate decision, since they are expected to cut rates for the second consecutive month by 25bps to 7.75 percent, according to 14 of the 15 economists polled by Bloomberg News. It is telling, though, that the last economist actually anticipates a 50bps cut. The key to the New Zealand dollar’s reaction, though, will be RBNZ Governor Bollard’s post-meeting commentary. Credit Suisse overnight index swaps are already pricing in nearly 150bps worth of rate cuts within the next 12 months, but if Mr. Bollard mimics his dovish policy statement from July, this sentiment will be exacerbated and the New Zealand dollar will likely plunge.

Terri Belkas is a Currency Strategist at FXCM.