U.S. Dollar Falls on Bailout Plan Disagreements

The U.S. dollar ended an extremely volatile week on a very weak note with speculation that the U.S. government bailout plan will fail to restore investor’s confidence in the U.S. economy. The U.S. dollar lost ground against many of the world’s most popular currencies and the greenback weakness was particularly evident against lower yielding currencies. For instance, the Swiss franc rose to 1.0898 francs per dollar on Friday from 1.1048 on Monday and the Japanese yen rose to 106 yen per dollar on Friday compared to 106.79 at the beginning of this week. Indeed, many investors are still waiting to see if the U.S. Congress will approve a $700bn plan that will enable a government sponsored agency to buy illiquid assets from several financial institutions banks and clean up their balance sheets from bad investments in mortgage backed securities. In addition, foreign exchange traders are also concerned over the implications of the biggest bank failure in history on the US economy. Washington Mutual customers withdrew nearly $17 billion since mid September and the bank stock started collapsing after its credit rating was dropped to junk by Standard & Poor's.

In the week ahead, a government report is likely to show a big loss on non-farm payrolls and that unemployment remains near 6%. These reports are likely to bring the U.S. dollar under pressure if investors start questioning the U.S. economy ability to continue to grow in face of job losses and a massive deleveraging in the financial sector. Yet, despite the recent wave of dollar weakness, we expect the U.S. dollar to rebound in the week ahead, particularly against the euro. Next week, the ECB is widely expected to keep rates unchanged at 4.25 percent but Jean-Claude Trichet is likely to acknowledge that recent economic data points towards a weakening of real economic growth in the euro zone economy and a more accommodative monetary policy could be needed to prevent the region from falling into a recession. On the other hand, a significant shift of interest rate expectations in favor of rate hikes by the Federal Reserve is likely to help the U.S. dollar to rally further against the euro.

Euro: Inflation And Comments Build A Case For An ECB Rate Cut Next Week

While price action in the euro was relatively staid through the end of the week, fundamental pressure continues to build into an inevitable break out for the currency. Like every other market, the euro was anchored as traders took measure of the stalled bailout plan in the US. Every day that passes without a stabilizing effort for the world’s financial and credit markets brings the Euro Zone closer to suffering its own localized crisis. Taking note of just such a possibility, ECB member Lucas Papademos said that he expects the slow down in growth to last longer than originally expected due to the banking crisis - though he leaned towards the economy avoiding a technical recession. An economic slowdown would certainly keep the calls for a rate cuts at high volume; but until inflation trends pull back towards target (or a deep recession forces the central bank’s hand), the group is likely to stick to their neutral bearing. However, we may start to see ECB President Trichet’s incessant focus on price growth crack relatively soon. Today, during the US session, the German Federal Statistics Office reported the preliminary CPI numbers for September. A second, consecutive contraction brought the annualized figure to 2.9 percent. While this is still a ways off the 2.0 percent target, it is also within what is considered the general tolerance band. However, it is the Euro Zone figures that will likely determine the timing of any policy shifts and next week’s CPI estimate figure for September is expected to slow, but only to 3.6 percent. Nonetheless, cooling inflation, slowing growth and an ongoing financial crisis bring the economy closer to rate cuts. As such, next week’s rate decision can be a market mover.

British Pound Looking At A Busy Fundamental Week Ahead

The usually volatile pound ended the week on a suspicious stable note. With nothing of importance crossing the economic wires, sterling traders were following the progress of the credit market bailout effort State-side after the Bank of England announced a coordinated injection of short-term liquidity into the market. The policy authority – along with the ECB and SNB – pumped another $74 billion worth of one-week funds into the market to hold companies through the quarter’s end. They had also announced a $40 billion repo operation for Monday. Aside from the US, the UK stands to suffer the most from ongoing financial stability. The credit-sensitive housing and consumer sectors are already failing quickly, and a broad recession seems but a breath away. Next week, we will take the full measure of credit conditions in the United Kingdom. Amid a busy calendar, general lending conditions will be measured by the BoE’s Credit Conditions Survey for the 3Q. Further refining the focus to consumers though, we will also take in net consumer credit and mortgage approvals for August along with second quarter housing equity withdrawals.

Japanese Yen Retraces Its Gains As Bailout Deadlock Curbs Risk Appetite

After a week of frustrating congestion, the Japanese yen finally found a spark Friday in a 200-point rally against the US dollar from Thursday’s highs as fundamental traders realized the US rescue plan was meeting more political resistance than many had expected. However, the impasse would not mean no bailout altogether. Indeed, US President Bush and representatives from both the Republican and Democrat parties assured the public that a deal would be struck – though when and to what affect is still a big question mark. Without doubt, the greatest burden to risk appetite now is the stability of the financial markets. Another seizure in the credit markets is a dangerously real possibility given current conditions. However, even when this immediate threat is lifted, demand for carry and risk in the currency market will still be stymied by the global economy’s steady cooling. Not only will this depress risk appetite; but will also (has already) lead to lower interest rates around the world. Therefore, the two key components for carry (risk and return) offer a dour outlook for this popular strategy under any scenario.

Terri Belkas is a Currency Strategist at FXCM.