Fundamental Outlook for US Dollar: Bearish

- Panic gripped the markets as US Treasury Bill Rates Drop to Lowest Since 1954
- Only two of the “big 5” investment banks exist following the failure of Lehman, sale of Merrill Lynch
- Federal Reserve leaves rate steady at 2.00%, signals neutral bias

After a wild week of trading, the US dollar ended the week lower 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 on Friday 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. 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 www.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.

There will be significant event risk on hand in coming days. 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.

Terri Belkas is a Currency Strategist at FXCM.