US Dollar Outlook Depends On Senate Approval of US Bailout Bill

The US dollar started the morning out on a strong note but subsequently pulled back on indications of a worsening contraction in the US manufacturing sector. The Institute of Supply Management’s (ISM) manufacturing index fell much more than expected to a reading of 43.5 in September from 49.9, marking the worst level since October 2001 and the third consecutive month below 50, which signals a contraction in business activity. Looking into the breakdown of the report, there were few positives. The production component dropped more than 11 points alone to its worst readings since February of 2001 while new orders and employment plunged to levels not seen since October 2001. The employment component is particularly concerning as US non-farm payrolls (NFPs) will be released on Friday and are expected to reflect hefty job losses for the ninth consecutive month, the worst run since NFPs fell negative during 20 of the 24 months from 2001 - 2002.

The fundamental aspects for the US economy remain grim, but that does not mean the US dollar cannot rally in this environment. Indeed, the US Senate is set to vote tonight on a $700 billion financial-rescue plan, tying it to an increase in FDIC insurance limits to $250,000 from $100,000 and a two-year extension of tax breaks in order to win support from Republicans. The bill is widely expected to pass the Senate vote, which will only add to speculation that the House of Representatives will approve it as well on its second time through on Friday. There is quite a bit riding on this bill, as evidenced by the massive declines in the US stock markets on Monday and if legislators want to maintain any semblance of financial market stability, they will vote in favor of it. There is significant debate over whom this bill benefits: Wall Street or Main Street? Clearly, Wall Street will be the biggest beneficiary of the bailout, but at this point, Main Street can’t function properly either if the credit markets are frozen. In the end, this may feel like choosing between the devil and the deep blue sea, but it could be the only quick way out of this mess.

Euro Slumps to 1.40 As Euro-zone Data Signal Recession, Key ECB Rate Decision on Thursday

The euro dropped to support at 1.40 this morning following a morning of news highlighting the recession risks for the Euro-zone’s economies. Indeed, manufacturing PMI for the region contracted more than initially estimated to 45 while the unemployment rate rose to 7.5 percent, the worst reading since April 2007. By nearly every measure, the Euro-zone is in danger. As a result, Credit Suisse overnight index swaps are pricing in almost 100bps worth of reductions during the next 12 months. So will we see a cut on Thursday morning when the ECB announces their next policy decision? According to a Bloomberg News poll, all of the 58 economists surveyed say no. While there are significant risks to the Euro-zone financial markets and economies, CPI is still well above the ECB’s 2.0 percent target. Since the ECB’s primary mandate is to maintain price stability, a rate cut would put their goal of cooling inflation pressures in jeopardy. However, I do think the euro will ultimately fall lower tomorrow morning, as ECB President Trichet’s post-meeting press conference at 8:30 EDT tends to be the main driver of price action. While he is sure to harp upon the need for price stability, he cannot ignore the potential for recession and risks to the European banking sector, and this is what is likely to trigger euro selloffs.

British Pound Plummets as UK Manufacturing Sector Contracts, Services Growth Stagnates

The British pound plummeted against the US dollar as we continue to see numerous signs of a recession in the UK. Indeed, manufacturing PMI contracted at the fastest pace in 16 years, as the index fell to 41 in September from 45.3. Meanwhile, an index of growth in the services sector stagnated for the first time since 2002. This helps to explain why Credit Suisse overnight index swaps are still pricing in over 125bps worth of rate cuts by the Bank of England (BOE) during the next 12 months. While the BOE is not anticipated to reduce rates at their next meeting on October 9, the sentiment alone is weighing heavily on GBP/USD. This sentiment may only be exacerbated on Thursday morning when the Bank of England Credit Conditions Survey for Q3 will be released. We already know that conditions must be pretty bad given the fact that two banks had to be nationalized this year, including Northern Rock in February and Bradford & Bingley just this past week. Thus, the BOE’s report will likely only highlight the extent of credit problems not only in the UK, but throughout the global financial markets. My fundamental bias for the British pound on Thursday: bearish.

Japanese Yen Falls As Jittery Traders Hope That US Bailout Bill Passes

The Japanese yen was generally weak across the majors as the stock markets held up well. In fact, the DJIA was down over 200 points by 11:00 EDT, but recouped most of its losses throughout the day to end down 19.59 points. News that Warren Buffet had bought $3 billion in preferred GE stocks helped to boot investor confidence, but the factor traders are really waiting on is the passage of the Treasury’s $700 billion bailout bill. The bill has been changed slightly to include an increase in FDIC insurance limits to $250,000 from $100,000 and a two-year extension of tax breaks in order to win support from Republicans, and as a result, it is expected to pass in the US Senate tonight. Such a result would add to speculation that it will pass in the House of Representatives – who voted it down on Monday – when they reconvene on the matter on Friday, and thus, could send risky assets surging. In the near-term, I think we’ll see the Japanese yen weaken if this bill is approved by the Senate. However, with the credit crisis still hitting the world’s financial markets quite hard, true financial stability is not likely to come soon. This leaves traders highly unlikely to pile back into the carry trade. My long-term fundamental bias for the Japanese yen: bullish.

Terri Belkas is a Currency Strategist at FXCM.