Dollar Lacks Direction As Market Focuses On Testimony

The U.S. dollar had a mixed performance on Wednesday. The greenback was particularly strong against low yielding currencies like the Japanese yen but lost some ground against commodity currencies like the New Zealand dollar and Australian dollar. Nonetheless, the currency market remains very volatile and the main focus has been on Capitol Hill where the Federal Reserve Chairman Ben Bernanke and Treasury Secretary Henry Paulson were giving their testimony. Indeed, many investors are waiting to see if the U.S. Congress will approve a $700bn plan that will enable banks to clean up their balance sheets from bad investments in mortgage backed securities. Yet, other investors are already making bets that those measures will not be enough to rescue the U.S. economy from a technical recession. In fact, regardless if the plan gets approved or not, the U.S. economy is likely to continue to face substantial challenges including further job losses, high energy prices and a rapid deleveraging in the financial sector. Moreover, some traders are concerned with the fiscal impact of the bailout plan which could cost almost 5 percent of GDP.

Just to put the size of the U.S. treasury bailout into perspective, one can look at the cost of the war in Iraq. Paulson's plan will cost $700bn or $30bn per month over the next two years. This is nearly three times more than the monthly cost of the war in Iraq which costs $10bn per month to the U.S. tax payer. Currently, the United States federal government runs a deficit of $438bn, or 3 per cent of gross domestic product and the bailout costs could push the fiscal deficit next year to $1 trillion or 7% of GDP. However, although no one can be sure that U.S. Treasury Secretary Henry Paulson’s plan to buy illiquid mortgage assets from several financial institutions is the best plan to deal with the current economic circumstances, it’s difficult to deny that the plan is not a good first step to restore confidence in the financial system. Indeed, the measures engineered by the U.S. Federal Reserve to clean the market from some toxic assets could be the beginnings of a more general recover in the appetite for risky assets like high yielding currencies. Looking ahead and despite the recent increase in volatility which makes it very difficult to make forecasts, I expect the U.S. dollar to rise further, particularly against the Japanese yen.

Euro: Financial Crisis Furthers Euro Zone Recession Fears

Considering the relative strength of the Euro across the market, it seems the currency is finding support from the central bank’s steadfast monetary policy stance and the optimistic outlook on growth and financial conditions. In fact, today, ECB board member Bonello said that he expected the worst has already passed for the Euro Zone economy and the fourth quarter would see a recovery. This optimism has certainly been absent in data however. Second quarter growth readings reported marked contractions in activity in both the major member economies and in the broader region. The outlook isn’t faring much better. Falling employment and wages is turning into a drop in spending, foreign demand is fading and now business activity is expected to depress growth even further. This morning, the German IFO business sentiment gauge tumbled more than expected. The headline Business Climate reading hit a three year low – not surprising considering the indicator’s trend and the additional weight imposed by the recent financial crisis. Far more concerning from a fundamental perspective though was the drop in the expectations component which hit a new 15 year low. If businesses plan to scale back going forward, the impact on employment and growth will be notable. Looking ahead, traders will be keeping their ears perked for any more ECB comments on the financial crisis and its impact on the Euro Zone; but there is also scheduled event risk to keep the market occupied. The money supply reading for August will give another inflation reading; but the real market mover will be the GfK Consumer Confidence Survey. We have already seen reports on investor and business optimism (both bad); but the consumer is the biggest component of growth, and their sentiment can truly alter growth and the euro.

British Pound Holds Steady Despite Weak Sales And Talk Of An Impending Recession

The UK economy is following quickly on the heels of the US in terms of economic activity. With the second largest economy in Europe already suffering from a stalled economy in the second quarter, a steep housing recession, overleveraged consumer credit, the recent financial crisis is added a new dynamic to consider. The quick deterioration in lending and investing has threatened to accelerate the economy’s descent into a crippling recession; and the market has in turn raised its expectations for the central bank to respond with relieving rate cuts. However, MPC member Andrew Sentance warned today investors and other BoE officials to avoid ‘overreacting’ to the financial crisis. In a speech today, the policy maker said central bank should focus on its inflation mandate as inflation is still at a decade high and the market turmoil would pass. However, the rest of his speech was hardly reassuring. Though Sentance expected a gradual recovery in the economy through 2009, he predicted “the economy could start to contract in the second half of this year or early in 2009.” Elsewhere in the market, the CBI Distributive Trades Report (essentially a retail sales indicator) dropped to its lowest levels since records began back in 1983. Considering policy officials have said they are paying less attention to the volatile government sales figures, this reading comes with considerable weight. With current sales, expected sales and orders all tumbling, a UK recession looks like a very strong probability.

Yen And Other Carry Sensitive Currencies Frozen As Risk Sentiment Hinges On Bailout

High and low yielders alike were relatively unmoved through Wednesday’s session as the market held its collective breath for some resolution on the US government’s bailout plan. With many pairs like USDJPY, AUDUSD and NZDUSD testing major technical levels, traders are obviously anxious to find some fundamental direction for risk appetite to work with. Looking ahead, economic data will have a greater weight on these pairs. The Japanese docket is scheduled to release August inflation number, Australia will take in new home sales data and the RBA semi-annual Financial Stability Review and New Zealand has its second quarter GDP release.

Terri Belkas is a Currency Strategist at FXCM.