US Dollar Could Falter As Federal Reserve Leaves Rates at 2.00%, Signals Neutral Stance

The Federal Reserve left rates unchanged at 2.00 percent, as we had anticipated, but subsequent market-wide reaction was mixed as fed fund futures had been fully pricing in a 25bp cut to 1.75 percent. Going forward, though, Credit Suisse overnight index swaps signal that the central bank will leave rates unchanged through the next 12 months - compared to expectations of a 25bp cut earlier today – as the Federal Open Market Committee’s policy statement signaled a more neutral stance. Indeed, it appears that the drop in crude oil from nearly $150/bbl in July down to below $95/bbl has helped to alleviate some of their inflation fears, since even the most hawkish member of the group – Richmond Fed President Richard Fisher – voted for no change. Furthermore, the Committee dropped a line noting “elevated” inflation expectations, suggesting they are a bit more confident that they’ve kept the public’s outlook for inflation in check.

Overall, the Committee’s balance of concerns regarding the “downside risks to growth and the upside risks to inflation” should lead them to leave rates steady through the end of the year. Looking more specifically at the market’s reaction, the US dollar jumped immediately on the news, but subsequently pulled back to pre-FOMC levels. Risky assets – like the JPY crosses – managed to stage a bit more of a recovery, though, amidst speculation that the Federal Reserve would bail out AIG, the world’s largest insurer. Ultimately, my fundamental bias for the US dollar remains bearish this week, as the previous rally was fueled by expectations of future interest rate increases. However, with the FOMC now signaling no change in rates going forward, that impetus has been removed.

British Pound Unfazed By Surge in UK CPI, BOE Minutes To Determine Next Move

The British pound slipped throughout the day despite surprisingly strong UK inflation numbers, as the headline reading rocketed to the fastest annualized pace in at least 11 years. Indeed, CPI growth accelerated to a 4.7 percent pace in August, which is well above the Bank of England’s 2 percent target and 3 percent limit. While oil prices may have fallen significantly during the survey period, gains in food, housing, and clothing costs picked up the slack. The news will be extremely disconcerting for the BOE, as they are already trying to grapple with tighter credit conditions and an economy teetering on the brink of recession. Indeed, this is much of the reason why Credit Suisse overnight index swaps are still pricing in over 100bps worth of rate cuts by the BOE during the next 12 months. However, the release of the minutes from the BOE’s September meeting on Wednesday morning could have a significant impact on these interest rate forecasts. During the August meeting, the minutes revealed that there was a 7-1-1 vote for the second consecutive month to leave rates at 5.00 percent, with one dissent in favor of a 25bp hike and one in favor of a 25bp cut. The vote this time around could easily be split again, so traders should watch out for a 8-1 vote (dissent in favor of rate cut) or a 6-2-1 (two dissents in favor of rate hike, one in favor of rate cut) as these will have the most severe impact on interest rate expectations. Biased comments within the minutes could skew the British pound’s reaction as well.

Euro Consolidates Above 1.41 As Euro-zone CPI Slows For First Time In 4 Months

The euro remained heavy on Tuesday as Euro-zone CPI slowed for the first time in four months in August, falling 0.1 percent during the month as the annual rate slipped to 3.8 percent from 4.0 percent. The drop in oil prices during the survey period certainly played a role in the decline, but with CPI still well above the European Central Bank’s 2 percent target, today’s readings may only have a marginal impact on their bias. Unlike the Bank of England and the Federal Reserve, the European Central Bank’s primary mandate is to maintain price stability, whereas the other central banks must focus on supporting economic growth while containing inflation at the same time. While Credit Suisse overnight index swaps are pricing in over 50bps worth of rate cuts by the ECB over the next 12 months, I do not expect them to do so before the end of 2008 unless CPI falls significantly lower from current levels. Furthermore, with 1.3880 serving as a critical support level for the EUR/USD pair, my bias for the euro is bullish, unless we see a break below that point.

Japanese Yen Tumbles As Investor Optimism Improves On Hopes Of AIG Intervention

The Japanese yen experienced wild volatility on Tuesday as risky assets tumbled early in the day amidst growing fears in the financial markets. However, these assets – including the Japanese yen crosses - subsequently surged higher despite the fact the Federal Reserve didn’t cut rates, on hopes that the central bank and US Treasury would step in and save the world’s biggest insurer, AIG. Indeed, the DJIA – which holds a strong correlation with forex carry trades – started the day down over 150 points, but rebounded to end the day up 140 points. The impact on the Japanese yen? The low-yielder plunged nearly 1 percent against the US dollar and fell approximately 1.15 percent versus the Canadian dollar and New Zealand dollar. Looking ahead to Wednesday, any sort of news regarding a solution for the solvency issues plaguing AIG will be good for risky assets and bad for the Japanese yen, especially since Morgan Stanley – one of the two remaining large investment banks (the other being Goldman Sachs) – reported Q3 net income losses that were slightly better than forecasts after the market close. In the long-term, though, my fundamental bias for the Japanese yen is bullish, as risk aversion is unlikely to fade completely anytime soon.

Terri Belkas is a Currency Strategist at FXCM.