US Dollar - Federal Reserve Unlikely to Cut Rates, But Policy Statement Could Weigh Heavily

Since the start of trading on Sunday, the US dollar has had a wild ride following the news that Bank of America would buy Merrill Lynch, Lehman Brothers filed for bankruptcy, and insurer American International Group (AIG) sought $40 billion in capital. At first, the US dollar weakened across the majors, but at the start of the European trading session, the currency rallied. However, toward the end of the NY trading session, the greenback started to pull back sharply again as risk aversion remains the predominant theme in the markets. This sentiment has led the DJIA to end the day down nearly 4.5 percent, while two-year Treasury notes saw yields plunge 49 basis points and fed fund futures shifted to price in a 72 percent chance that the Federal Reserve would cut rates on Tuesday afternoon. The big question is: will they actually do it? I don’t believe they will, as they’ve already attempted to address liquidity issues by expanding their lending facilities by accepting a broader range of collateral. However, the key to trading the US dollar on Tuesday will be the bias reflected in the Fed’s policy statement. They will likely note the substantial downside risks to growth, especially those stemming from financial instability, but if they go on to say that price pressures could ease in coming months, the markets will likely shift to price in rate cuts before year-end and send the US dollar lower. My fundamental bias for the US dollar this week: bearish.

Japanese Yen Dominates As Risk Aversion Reigns

The Japanese yen rocketed higher on Monday as traders unwound positions in risky assets, as the yen is one of the key components of the forex “carry trade.” In fact, the yen managed to gain the most versus high-yielders like the Australian dollar and New Zealand dollar, but also rallied against everything form the Canadian dollar to the British pound. There were other indications of market-wide risk aversion as well, as the DJIA ended the day down over 500 points, demand for Treasuries surged, and the CBOE’s VIX Volatility Index hit the highest levels since the Bear Stearns fiasco in March. Indeed, with the Japanese Yen interest rate forecast looking neutral, the currency will be particularly vulnerable to choppy price action. If fears for the health of the financial markets linger into Tuesday’s trading day, the Japanese yen is likely to see additional gains.

British Pound Awaits Release of UK CPI on Tuesday

The UK economic calendar was empty today, but one thing is clear: the outlook for the economy is bleak, and that is why Credit Suisse overnight index swaps are pricing in over 100bps worth of rate cuts by the Bank of England over the next 12 months. That said, I still see upside potential for the British pound. This is mostly due to my dollar bearish bias, but we also have to look to the release of UK CPI on Tuesday morning. Indeed, consumer price growth in August is expected to accelerate even faster to a 4.6 percent annual pace, which would mark the sharpest rise since May 1992. Inflation remains of great concern to the Bank of England, but the BOE has a dual mandate to maintain price stability and to promote sustainable growth and employment. The UK has already seen indications of a broad economic slowdown, but adding the fragile nature of the UK’s financial sector to the mix puts the Bank of England in a particularly precarious position, as a rate increase meant to fight inflation could easily push the UK into recession and trigger a severe credit crisis. As a result, the UK's MPC will likely continue to sound hawkish on inflation in order to contain consumer inflation expectations, but when it comes down to it, their bark may be bigger than their bite as the Bank of England is highly unlikely to actually raise rates. Nevertheless, very strong UK CPI figures could lead the British pound to rally upon release, while soft reading could weigh the currency down.

Euro Manages to Gain, But ECB Rate Outlook Leaves Recovery In Danger

The Euro barely managed to eke out gains versus the greenback on Monday, and while the markets have been focused on the potential for a rate cut by the Federal Reserve on Tuesday, the outlook for European Central Bank interest rates is not necessarily euro bullish. In fact, Credit Suisse overnight index swaps are pricing in over 50bps worth of rate cuts by the ECB over the next 12 months, compared to 42bps on Friday. However, from a technical perspective, EUR/USD has managed to hold above intraday trendline support at 1.41 and the 61.8% fib of 1.3880 - 1.4484 at 1.4111. Realistically, the Fed’s rate decision and policy statement will be the key determinants of where EUR/USD goes next, and given my outlook for a dovish result, my bias for the euro this week is bullish.

Terri Belkas is a Currency Strategist at FXCM.