Fundamental Outlook for US Dollar: Bearish

- Bailout plan held up in Congress, financial market’s fate hangs in the balance
- Final reading of 2Q GDP unexpectedly cools – a first step to second half recession?
- Market pricing in Fed rate cuts as financial crisis and recession fears dominate

Volatility dominated the dollar landscape this past week, but direction was notably absent. However, looking at the building fundamental pressure behind the ongoing financial crisis - and the expectations for rate cuts that have been laid bare by this uncertainty – the potential for breakouts across the majors is material. First and foremost, fundamental greenback traders’ main concern in the days ahead will be the progress of the proposed bailout plan. The necessity of this financial market rescue couldn’t have come at a worst time as politicians bidding for control of Washington have held up this vital piece of legislation due to concerns that a signature on this bill would draw the resentment of constituents. However, the longer it takes to pass a viable plan, the more likely it becomes that another major bank will be forced into bankruptcy. What’s more, with Washington Mutual just another casualty of the market crunch (since the bailout was proposed), the threat of another infectious panic is certainly growing.

On the other hand, even if Congress can hammer out the details of a financial rescue, they may still come up short of reviving lender and investment confidence. In most of the major failures that have resulted from the subprime meltdown, the final nail in the coffin has come from a panic withdrawal of deposits and capital as opposed to business-ending losses. Therefore, the perception of stability and low counter-party risk will need to spread into the global markets to truly take effect. However, even if these immediate fears are purged, we are still left with the long-term economic consequences of this crippling period. Many market participants had believed the US economy was heading for a recession even before this fundamental stress was added. In recent weeks, the bears have certainly multiplied. These dour growth forecasts have further boosted the probability of rate cuts – dramatically. Fed Fund futures are fully pricing in a 25bp rate cut for the October 29th meeting and there is a 32 percent chance that the central bank will act by slashing the benchmark by half a percent.

While the financial crisis and rate expectations will be two, overwhelming influences on the US dollar for some time to come, the economic calendar will offer more of a regiment to event risk. Topping the list of indicators due for release is the monthly non-farm payrolls report (NFPs). This indicator has been put on the back burner recently, but an expected ninth consecutive contraction would draw further comparison to the employment conditions back in 2001/2002 – during the country’s last recession. Other indicators will offer a broad gauge of economic activity through the third quarter. Consumer spending (which accounts for an estimated 80 percent of US growth) will be measured through personal consumption expenditure, personal income and personal spending indicators. Other growth readings will come in the form of the ISM manufacturing and service sector reports – both readings are expected to have contracted through September.

John Kicklighter a Currency Strategist at FXCM.