US Dollar Plummets More Than 2% as Credit Concerns Linger

The US dollar plummeted more than 2 percent against the euro on Monday, especially as shifting interest rate expectations start to move in favor of the euro and British pound. Financial market news will likely remain the predominant driver of the markets in coming weeks, especially since it appears that massive consolidations in the banking sector are going to take place. The first sign? Goldman Sachs and Morgan Stanley were granted approval to become bank holding companies, and thus, will now be regulated by the Federal Reserve. Indeed, the days of the “big 5” investment banks are gone, as Lehman Brothers went bankrupt, Bear Stearns and Merrill Lynch were bought out, and now we have the transformation of Goldman and Morgan Stanley. The change will help the two survivors do two things: gain liquidity via deposits as financing will likely remain a problem in coming weeks, as well as put them in better positions to be acquired, to merge or to acquire smaller retail banks. On the other hand, they will also be subject to new capital requirements, additional oversight, and far lower profit margins. Nevertheless, it’s worth wondering if anyone will be seeing the sort of profits they’ve made in recent years, as asset deflation may serve as a threat for quite some time.

This has not stopped foreign banks from trying to get a deal on US banks, though, as Mitsubishi UFJ - Japan's largest bank - announced a plan to buy a 10-20 percent stake in Morgan Stanley. Likewise, Nomura Holdings - Japan's largest brokerage house - is paying $225 million for the Asian operations of Lehman Brothers. In what seems to be the norm nowadays, when the US hits bouts of financial distress, the government and financial institutions rely on foreign banks and sovereign wealth funds to save the day.

There is little in the way of US economic data scheduled for release in the next 24 hours, but traders should watch for testimony by Treasury Secretary Paulson and Federal Reserve Chairman Bernanke at the Senate Panel since it is sure to yield commentary on the latest credit turmoil. Furthermore, since Mr. Bernanke is speaking, his comments could potentially shake up US interest rate expectations. My fundamental bias for the US dollar this week remains bearish, especially as the Treasury’s $700 billion plan could be widened from just mortgage-related assets to include everything from car loans to credit card debt. These sorts of assets were poisonous for the balance sheets of financial institutions, and will be similarly toxic for the US government.

Canadian Dollar, Australian Dollar Up 1% On Record $25/bbl Gain in Crude Oil

The Canadian dollar and Australian dollar both rocketed over 1 percent higher against the greenback on Monday, propelled by a surge in commodities. It was tough to avoid the headlines noting the $25/bbl jump in crude oil futures, as the move marked the biggest one-day gain in its exchange-traded history. While much of this had to do with the fact that expiry fell on Monday’s close for the benchmark contract, the price action was still significant. USD/CAD had some Canadian fundamental charge behind it as well, as retail sales rose for the fifth consecutive month in July, led by furniture, building supply, and pharmacy sales. However, the gains were not quite as high as expected, as the headline retail sales index rose 0.1 percent while sales excluding autos picked up 0.4 percent. Nevertheless, the data suggests that the Canadian economy has held up well in recent months - despite the US economic slowdown - as domestic demand supports growth. Looking ahead to Tuesday, Canadian CPI for the month of August is anticipated to rise to an annualized pace of 3.5 percent – a more than 5 year high – while the Bank of Canada’s core CPI may hold steady at 1.5 percent. However, there is potential for the headline reading to reflect softer inflation pressures given the broad decline in commodity prices during the survey period, and this surprise factor could weigh on the Canadian dollar. On the other hand, a weakening in the currency over the past few months could boost import price inflation, providing potential for a hot number. My technical bias for the commodity dollars (AUD, NZD, CAD) for Tuesday is bearish, as they have all run in to key resistance levels and I think we’re likely to see at least a slight pullback.

British Pound Rallies More Than 300 Points Despite Heavy Downside Risks for UK Economy

Credit Suisse overnight index swaps may be pricing in just over 75bps worth of rate cuts by the Bank of England over the next 12 months, but given its sharp shift from pricing in 116bps worth of cuts just last week, the British pound managed to rally over 300 points against the greenback. Indeed, the move came despite dismal UK economic data, as the Rightmove house price index fell negative for the fourth consecutive month in September, which signals a potential housing recession that will rival only that of the US. That has mattered little to traders though, as the financial crisis appears to be taking a much harder toll on the US, and thus, leaves the odds in favor of further GBP/USD gains.

Japanese Yen Mixed as 3.3% Drop in DJIA Signals Risk Aversion

The Japanese yen held its own against the US dollar, Kiwi, Aussie, Loonie and British pound, but fell against currencies like the Swiss franc and euro. Indeed, the gain against the higher-yielding commodity currency signals a sell-off in carry trades, and this is something we often see with sharp declines in US equities, such as the 3.3 percent drop in the DJIA on Monday. In Japanese news, Taro Aso - a former foreign minister - won the race on Monday to become Japan's next prime minister and will take over for Yasuo Fukuda, who abruptly resigned early this month amidst recession fears and global financial market turmoil. Mr. Aso appears to be quite bearish on growth, saying that in his travels around the regions, he became “even more convinced that the economy was in a recession.” Nevertheless, my long-term bias on the Japanese yen is bullish, as bouts of risk aversion will last for quite some time and Japanese fundamentals rarely have a big impact on the currency.

Terri Belkas is a Currency Strategist at FXCM.