US Dollar Stages Last Minute Rally, DJIA Posts Biggest Gain Since March 2003

It was a wild day for the US dollar, as the currency started the day on a weak note versus most of the majors, but ended the day with a strong rally. As we’ve seen over the past few days, the biggest moves seem to be occurring during the final hour of trading in the NY markets. The latest spark? News that the government is formulating a “permanent” plan to aid the financial markets along with new rules against short sales in the US and the Federal Reserve's $180 billion emergency liquidity injection helped to improve investor confidence. Indeed, at the very end of the trading day the US dollar recovered nearly half of its losses while the DJIA surged 3.6 percent, the biggest gain since March 2003. Likewise, fed fund futures shifted to price in a 78 percent chance of a 25bp cut next month, compared to 100 percent yesterday. Nevertheless, downside risks remain for the US dollar, as futures are still fully pricing in a 25bp cut before the end of the year. Furthermore, with the global credit crunch leading liquidity to drop substantially, we’re likely to continue seeing extreme volatility throughout the markets.

In economic news, the US leading economic index for the US fell more than expected in August at a rate of 0.5 percent, marking the second consecutive decline. Looking at a breakdown of the leading indicator, the sharp deterioration in the labor markets along with weak prospects for the housing market weighed heavily. The stock price and interest rate spread components were actually strong points this time around, but given the financial turmoil that has evolved recently, these factors could send the September reading of the US leading index down sharply. Looking ahead to Friday there will be no data on hand for the greenback, and thus, trading of US assets will likely remain contingent upon risk trends market-wide. My fundamental bias for the US dollar in the longer-term remains bearish, but if we see investor sentiment improve slightly on Friday, the currency could actually end the week on a strong note.

British Pound: Why the Jump in UK Retail Sales Was Deceiving

Though holding within a range of approximately 1.8100 - 1.8250, the British pound shot higher this morning on the release of UK retail sales as the index unexpectedly jumped for the second consecutive month. Indeed, a breakdown of the report shows that the 1.2 percent rise in August was due primarily to gains in sales of clothing and footwear. Nevertheless, as we mentioned yesterday, the Bank of England has noted in the past that they focus more on private surveys over government statistics, as the latter tends to be extremely volatile. Looking at the latest private numbers, BRC same-store sales plunged 1.0 percent in August from a year earlier, signaling that consumption is far from resilient. As a result, there are still downside risks for the British pound from a fundamental perspective, especially since Credit Suisse overnight index swaps are pricing in nearly 100bps worth of rate cuts by the Bank of England.

Euro Consolidates Above 1.43, Swiss National Bank Leaves Rates at 2.75%

There was no data on hand from the Euro-zone and as usual, we saw that EUR/USD price action was dictated by the greenback. The pair saw a range of over 200 points on Thursday, but ended the day near the bottom just above 1.4300. As we mentioned in the US dollar section, if we see investor sentiment improve slightly on Friday, the dollar could actually end the week on a strong note and weigh EUR/USD down. Meanwhile, the Swiss National Bank (SNB) left the target range for Swiss franc three-month Libor unchanged at 2.25-3.25 percent, and the Bank said that they intend to hold the rate in the middle of the target range for the time being. Referencing the recent financial instability, the SNB suggested that no rate cut was needed since they were continuing their “generous and flexible provision of liquidity” to the markets. In fact, it is clear that the SNB was previously inclined to increase rates, as they said that the prospect of easing inflation allowed them to leave rates steady. Overall, we see that Credit Suisse overnight index swaps are pricing in no change in rates by the SNB over the next 12 months, which is similar to what we have with the Japanese yen and the Bank of Japan. Thus, risk trends remain the dominant driver of the Swiss franc (and the Japanese yen), as fundamentals rarely have a lasting impact on the currencies.

Japanese Yen Dives on Rebound in Carry Trades

The Japanese yen plummeted across the majors on Thursday – especially the high-yielding Australian and New Zealand dollars – as carry trades made a comeback. Indeed, news that the government is formulating a plan to aid the financial markets along with new rules against short sales in the US and the Federal Reserve's $180 billion emergency liquidity injection helped to improve investor confidence. It remains to be seen whether this sort of sentiment will hold, and the next move for carry trades will likely depend on if an official plan is announced on Friday. Overall, my long-term bias on the Japanese yen is bullish, as I believe that bouts of risk aversion will last for quite some time.

Terri Belkas is a Currency Strategist at FXCM.