Euro/US Dollar Rallies on Jump in Investor Confidence - Will the Move Continue?

The US dollar plunged nearly 1 percent against the euro and also fell versus most of the majors on Friday – especially the commodity dollars – as prospects of further intervention by the US government in the financial markets provided a boost to carry trades. Indeed, with the fed funds rate sitting at 2.00 percent, the US dollar is essentially a low-yielding currency like the Japanese yen. While there is no plan set in stone quite yet, US Treasury Secretary Henry Paulson said during a speech at 10:00 EDT that the Treasury would expand their mortgage-backed security (MBS) purchase program announced earlier in the month in an attempt to remove toxic debt from the balance sheets of financial institutions. Furthermore, Mr. Paulson said that Fannie Mae and Freddie Mac would increase their MBS purchases, and that a permanent plan would likely be made over the weekend to address the stresses in the financial markets.

The market’s response? Buy all things associated with risk such as oil, stocks, and the Japanese yen crosses, while selling “safe-haven” assets like US and European government bonds, the US dollar, and gold futures. Looking ahead, it appears that there is still a good amount of bearish potential for the US dollar going forward. According to the latest CFTC Commitment of Traders (COT) report for the week ended September 16, positioning grew increasingly bearish on EUR/USD and as a contrarian indicator, the data signals possible gains for the pair (see full analysis of the COT report on Monday on DailyFX.com). On the other hand, the massive sell-off in Treasuries also led fed fund futures to shift to only price in a 28 percent chance of a 25bp cut by the Federal Reserve on October 29, compared to 82 percent on Thursday. Nevertheless, with European Central Bank interest rates a solid 225bps higher than that of the US at 4.25 percent, these differentials have supported EUR/USD strength as the pair continues to trade within a massive range of 1.42 - 1.45.

Looking ahead to next week, there will be significant event risk on hand. First and foremost, traders need to watch for an announcement on Sunday from US Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke since they are expected to release details for a plan to take mortgage-related debts from financial institutions that will cost “hundreds of billions” of dollars. This sort of news could be beneficial for carry trades and negative for low-yielding currencies, and with Mr. Paulson and Mr. Bernanke both scheduled to speak multiple times during the week, volatility should remain high. In economic news, US Existing Home Sales and Durable Goods Orders are both anticipated fall negative while Q2 GDP is not expected to be revised from 3.3 percent. Likewise, Euro-zone services and manufacturing PMI are both forecasted to reflect contractions in the respective sectors for the fourth consecutive month, adding to the pile of evidence suggesting an impending European recession. My fundamental bias for EUR/USD next week: bullish.

British Pound Surges Nearly 400 Points From Friday’s Lows

Credit Suisse overnight index swaps may be pricing in nearly 100bps worth of rate cuts by the Bank of England over the next 12 months, but that didn’t stop the British pound from surging from early morning lows of 1.7914 to an intraday high of 1.8388. Indeed, a jump in risk-seeking activity led carry trades higher, and with an interest rate of 5.00 percent, the pound drew quite a bit of attention. Looking ahead to the next week, GBP/USD price action will depend on news out of the US. UK releases include: Rightmove house prices on Sunday, BBA mortgage loans on Tuesday, and Nationwide house prices on Thursday. The deterioration of the UK housing sector rivals that of only the US, and as a result, disappointing data could weigh on the British pound.

Japanese Yen Hit Harder Than the Greenback on Rebound in Risky Assets

The Japanese yen plummeted across the majors – especially against the high-yielding Australian and New Zealand dollars – as carry trades made a comeback. Indeed, news that the government would take toxic mortgage-related debt from financial institutions revived interest in stocks and the Japanese yen crosses.. It remains to be seen whether this sort of sentiment will hold, and the next move for carry trades will likely depend on if the Treasury and Federal Reserve announce permanent plans over the weekend to bail out the financial sector. 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. However, demand for carry may lead to yen weakness next week.

Commodity Dollar Benefit From Demand For Yield, Downside Risks Next Week

Global improvements in investor sentiment, a surge in carry trades, and a jump in oil all helped lead the commodity dollars higher on Friday. Versus the US dollar, the Canadian dollar rose 1.3 percent, the New Zealand dollar increased 1.82 percent, while the Australian dollar gained a whopping 3.65 percent. There has been little in the way of economic data for the commodity dollars lately, but that will change next week. On Monday, Canadian retail sales are expected to rise 0.3 percent, though there is potential for a surprisingly strong reading given the surge in Canadian wholesales sales, which tends to be a decent leading indicator. On Tuesday, Canadian CPI for the month of August could actually reflect softer inflation pressures given the broad decline in commodity prices during the survey period. On Thursday, New Zealand Q2 GDP is likely to reflect a continued contraction in the economy for the second consecutive quarter, which would fit the broad definition of “recession.”

Terri Belkas is a Currency Strategist at FXCM.