US Dollar Vulnerable To Weakness On Fed Cut Expectations, Financial Instability

The US dollar fell sharply on Wednesday as the markets are now weighing the odds of a rate cut before the end of the year. This is exactly the sort of trigger I was talking about yesterday when I cited by my bearish fundamental bias for the US dollar, 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 and possibly considering cutting rates, that impetus has been removed. Indeed, much to the dismay of the Fed, their intervention in AIG failed to soothe investors’ fears about the health of the markets, as indicated by the 4% or more drops in the DJIA and S&P 500. These moves were led by declines in financials, as shares of the two remaining “big 5” investment banks fell by the most on record. This risk aversion also translated into massive flight-to-safety toward US Treasuries, as yields on 3-month Treasury bills fell to a 54-year low. (Check out our US Trading Summary). Putting the focus back on the Federal Reserve, fed fund futures are fully pricing in a 25bp cut on October 29 and a 34 percent chance of a 50bp cut. Meanwhile, Credit Suisse overnight index swaps are close to pricing in a 25bp cut within the next 12 months, compared to expectations for a 25bp hike just last Friday. Clearly, the markets have taken the Fed’s more neutral stance to heart following the FOMC rate decision and policy statement on Tuesday, and as a result, the US dollar will remain vulnerable to additional decline. Thus, my fundamentals bias for the US dollar remains bearish.

British Pound: Banking Consolidations Not Contained To the US, UK Retail Sales Likely to Drop

The US is not alone in experiencing massive banking consolidations, such as the sale of Merrill Lynch to Bank of America, as UK bank Lloyds TSB will reportedly acquire HBOS, which is the nation's biggest mortgage lender. Indeed, after the nationalization of Northern Rock earlier in the year, the UK government is surely looking to avoid having to take such measures once again. Meanwhile, the minutes from the Bank of England’s September meeting revealed an 8-1 vote in favor of leaving rates steady, with one dissent in favor of 50bp cut. With UK CPI well above the BOE’s 2 percent target and 3 percent ceiling, the central bank really has limited room to consider cutting rates despite obvious signs of a sharp economic slowdown in the country. Furthermore, since CPI has held above the 3 percent ceiling for 3 months, BOE Governor Mervyn King had to pen yet another letter to Chancellor of the Exchequer Alistair Darling explaining the inflation situation. In it, Mr. King suggested that the BOE would leave rates unchanged at 5.00 percent, and allow the economic slowdown to bring inflation pressures down on their own. However, given the significant turmoil in the financial markets, it remains to be seen how long they will maintain this stance.

Looking ahead to Thursday, UK consumer spending is anticipated to have slowed in August, as retail sales are forecasted to fall 0.5 percent, dragging the annual rate to a more than two year low of 1.6 percent. The latest BRC retail sales numbers support the case for such a move, as their measure of same-store sales plunged 1.0 percent in August from a year earlier. However, this is not the most reliable leading indicator: last month, the BRC’s figures reflected a 0.9 percent decline from a year earlier, while the UK government’s statistics showed a 0.8 percent monthly gain and a 2.1 percent annualized rise. That said, the Bank of England has noted in the past that they may focus more on private surveys over government statistics, as the latter tends to be extremely volatile. As a result, traders should keep in mind that regardless of this upcoming number, the BOE likely still holds a bearish view of UK consumer spending.

Euro Surges Despite Widening Trade Deficit, Swiss National Bank Expected to Leave Rates at 2.75%

The euro rocketed against the US dollar on Wednesday due to a variety of factors, including a 6.4 percent jump in WTI crude oil futures (dollar bearish) and shift in Federal Reserve interest rate expectations to price in at least a 25bp cut by December (dollar bearish). Meanwhile, Credit Suisse overnight index swaps are still pricing in just over 50bps worth of rate cuts by the European Central Bank within the next 12 months. However, I do not expect them to do so before the end of 2008 unless CPI falls significantly lower from current levels. Keeping in mind the potential for US dollar weakness, my bias for the euro remains bullish, barring a drop below 1.3880. Meanwhile, the Swiss National Bank (SNB) is anticipated to leave rates unchanged at 2.75 percent tomorrow morning, as the Swiss economy holding up fairly well thanks to robust domestic demand and price pressures still strong. What about the incredibly instability in the markets? The SNB has tried to address liquidity issues in a one-day operations on Tuesday and Wednesday, as SNB Vice-Chairman Philipp Hildebrand said, "The current events in the United States show that it is still too early to say the storm is over.” Nevertheless, like the low-yielding Japanese yen, my bias is in favor of Swiss franc strength amidst broad-based risk aversion in the markets.

Japanese Yen Mixed as Risk Aversion Rattles Risky Assets

The Japanese yen experienced wild volatility on Wednesday as the DJIA plummeted over 4 percent while flight-to-safety sent yields on 3-month Treasury bills to 54 year lows. Indeed, the low-yielder plunged nearly 1 percent against the British pound, but jumped over 2 percent versus the Australian dollar. Looking ahead to the remainder of the week, traders should keep an eye on risk trends as this should remain the predominany driver of Japanese yen price action. Furthermore, in the long-term, 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.