Fed Chairman Ben Bernanke opened the door to rate cuts during a speech on Tuesday, while a record decline in consumer credit suggests spending may fall signficantly through the end of the year.

US Dollar Slips As Bernanke Brings Fed Rate Cuts Back Into Focus

The US dollar saw a choppy day of price action but ended the day lower versus most of the majors as US fundamental factors were broadly bearish. Indeed, during a speech to the National Association for Business Economics this afternoon, Federal Reserve Chairman Ben Bernanke opened the door to rate cuts at their next meeting on October 29. In his comments, Mr. Bernanke said that inflation is likely to ease, and that "the outlook for economic growth has worsened and that the downside risks to growth have increased. At the same time, the outlook for inflation has improved somewhat, though it remains uncertain. In light of these developments, the Federal Reserve will need to consider whether the current stance of policy remains appropriate." The release of the FOMC minutes from September reiterated this sentiment, focusing on the downside risks to growth stemming from financial instability. Fed fund futures have been pricing in a 50bp cut for a while, but it is only now that we have reason to believe that such a move could actually happen due to this specific commentary by the Federal Reserve.

Furthermore, consumer credit growth in the US fell for the first time in over 10 years and by the most since record-keeping began in 1943, adding to evidence that consumer spending is bound to pull back sharply through the end of the year as the global credit crunch impacts nearing every part of the economy. According to the Federal Reserve, consumer credit fell by $7.9 billion in August, down 3.7 percent from a year earlier, due primarily to weaker non-revolving credit like auto loans. Indeed, this makes the point that the credit crisis the markets are facing isn't one that just hurts Wall Street, but impacts Main Street as well. If banks will not lend to each other, they won't be lending much to businesses and consumers either. As we’ve discussed recently, US consumers are particularly used to living with a high amount of debt. With the availability and demand for credit falling rapidly, retailers are sure to feel the repercussions. It will be interesting to see if this bearish US sentiment will hold, or if lingering risk aversion will drive demand for US Treasuries and thus, the US dollar. My fundamental bias for the US dollar in the long term: bullish. However, I do think there’s room for the currency to pull back in the near term.

Euro, British Pound Gain Slightly, But Outlook Remains Bleak as Iceland Pegs Krona

The euro and the British pound edged higher on Tuesday, but it looked to be more of a technical retracement than anything else as there is little evidence that conditions are improving in the European financial markets. A region that we don’t normally focus on as it is not part of the “Euro-zone”, but is considered a part of Europe, is Iceland. Without a doubt, Iceland has really felt the brunt of this financial crisis from a currency perspective and on Tuesday the Central Bank of Iceland moved to fix the value of the Icelandic krona to 131 against the euro following a more than 40 percent decline since the start of September. Due to the Central Bank of Iceland's high 15.50 percent interest rate and monstrous current account deficits - which amounted to 34 percent of GDP at the end of June - Iceland's krona faced heavy speculative selling, especially as risk aversion drove carry trade selloffs. Meanwhile, the country is struggling with liquidity issues, and the government is reportedly in talks with Russia to agree on a 4 billion euro loan.

Iceland's Prime Minister Geir Haarde said, “In a situation like this it’s turning out that it’s every man for himself, every country for itself, everybody’s taking care of their best interest and that’s what we are doing." Mr. Haarde's comments highlight the lack of unity and support between Europe's individual countries and economies, which is doing little boost global investor sentiment. Indeed, a statement from the Ecofin Council of 7 this afternoon had little impact as it held few concrete details, with the exception of an agreement to provide deposit guarantee protection for individuals of at least 50,000 euros, though many Member States had already said they would raise their minimum to 100,000 euros. This leaves Friday's G7 meeting in Washington all the more important, as this would provide a prime opportunity to announce some sort of solution. However, as we found this past weekend following a meeting of the leaders of Europe's four largest economies - Italy, France, Germany, and Britain - no formal plan can easily trigger additional bouts of risk aversion in the markets.

Japanese Yen Could Rally As SEC Short-Selling Ban Due To Expire On Wednesday

The Japanese yen jumped more than 2 percent against high-yielders like the Australian dollar and New Zealand dollar on Tuesday, but simply treaded water versus the US dollar, British pound, and euro. Nevertheless, risk aversion remains a big threat, especially as Wednesday marks the expiration date of the SEC's ban on short-selling of financial stocks will expire. With bearish investors finally able to sell shares once again, this could spur further weakness in the stock markets and the Japanese yen crosses, translating into additional strength for the low-yielder. 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.