US Dollar: Does the Federal Reserve Have Any Other Tricks Up Their Sleeve?

The US dollar was mixed versus the majors on Wednesday amidst global central bank rate cuts early in the morning, including a 50 basis point reduction to the fed funds rate. This was the first unscheduled rate cut since January 22, and while we had been anticipating an impending easing of monetary policy following Fed Chairman Ben Bernanke’s comments on Tuesday, the coordinated effort between the Fed, European Central Bank, Bank of England, Swiss National Bank, Bank of Canada, People’s Bank of China, and Sweden’s Riksbank was completely unprecedented. So what kind of impact did the move have? Actually, not much. The US dollar ended the day up against the British pound and commodity dollar while edging back versus the euro, Swiss franc, and Japanese yen. The most disappointing reaction, though, was in the stock markets as the DJIA ended the day down 189 point while an apparent lack of confidence in government debt led Treasuries to sell off as well. The Fed and other central banks have really been pulling out all the steps in the hopes of firing a single silver bullet that would help to calm the money markets, bring skyrocketing overnight interest rates down, and put a floor under the falling equity markets.

Unfortunately, this coordinated effort has not done the trick, and it’s worth wondering if Mr. Bernanke has anything else up his sleeve. Beyond the expansion of the Fed’s lending facilities and a 25bp rate cut at the end of the month, the markets will likely only be able to pin their hopes have to rely on something fruitful coming from the implementation of the Treasury’s $700 bailout bill. For US dollar traders, this makes using technical levels all the more important since jittery market sentiment leaves currencies prone to high volatility, and in that environment, forex market movements do not necessarily follow the logic of fundamentals on a day-to-day basis (as we saw last Friday with US non-farm payrolls).

Euro Holds Its Own As ECB Signals Rate Cut Is a One-and-Done Deal

The European Central Bank (ECB) is one of the most hawkish and stubborn monetary policy makers, as they went on the hike rates right up until July as credit conditions worsened and left rates unchanged at their meeting last week. However, in an effort to show solidarity with the likes of the Federal Reserve and Bank of England, the ECB set their primary mandate of price stability aside for a day to slash rates by 50bps to 3.75 percent. However, unlike the central banks of the US and UK, the ECB’s subsequent press release had very little substance, as they simply said that “upside inflation risks” had decreased, but jumped right back into hawk mode when they said that by keeping inflation expectations in check and “securing price stability” would be supportive of economic growth and financial stability. That may not have been what European banks and businesses wanted to hear in light of the credit crisis, but it did help to support EUR/USD throughout the day. Nevertheless, Credit Suisse overnight index swaps are pricing in over 125bps worth of cuts by the ECB over the next 12 months, which leaves the odds in favor of further declines in the euro in the long term.

British Pound Tumbles As BOE Slashes Rates, UK Announces £50 Billion Bailout

We’ve known for a while that the UK economy and financial markets were in rough shape, but the announcement of a massive bailout plan by the UK government made it incredibly obvious how dire the situation is and sent the British pound plummeting over 300 points against the US dollar. Indeed, along with the Bank of England’s 50bp cut to the Bank Rate to 4.50 percent, the UK Prime Minister Gordon Brown announced a plan to inject £50 billion worth of taxpayer money into banks including Abbey, Barclays, HBOS, HSBC, Lloyds TSB, Nationwide Building Society, RBS and Standard Chartered. This differs from the US bailout though, as the UK government will seek shares of the companies in return, and provided that the markets eventually recover, taxpayers should see a return on the “investment” when share prices improve. In addition to this though, £200 billion will be available under the Special Liquidity Scheme, which will facilitate the exchange of some illiquid assets for UK Treasury Bills. The problem, however, is not necessarily liquidity but a pronounced lack confidence, and there’s only so much the UK can do on their own to fix that. I think there’s major downside potential for the British pound in the long term, though I wouldn’t be surprised to see a short-term bounce within the next few days. In that environment, it may be best to sell rallies in pairs like GBP/USD.

Japanese Yen: Odds Remain Stacked In Favor of Strength

The Japanese yen outperformed, as usual, as risk aversion remained the dominant trend in the markets. In fact, according to our latest forex correlations report, pairs like USD/JPY remain highly sensitive to the DJIA as evidenced by the similarly choppy price action in both today. At the end of the day, the Japanese yen finished up over 1 percent against the euro and US dollar, roughly 3 percent versus the Canadian dollar and British pound, more than 5 percent again the New Zealand dollar and a whopping 7.21 percent against the Australian dollar. Meanwhile, the Bank of Japan was one of the only major central banks to not cut rates in the coordinated move today, though they did issue a statement of strong support. Indeed, with interest rates at an ultra-low 0.50 percent, the Bank of Japan has little room for maneuver. Going forward, the odds remain in favor of Japanese yen strength as the unprecedented actions by the world’s biggest central banks had little impact on the markets, and tonight at midnight the SEC’s ban on short-selling of financial stocks will come to an end. The end of the ban isn’t expected to trigger a surge in short-selling, since the practice is now more expensive and financial shares have fallen so much that even the biggest bears may not find it worthwhile to sell. Nevertheless, it is clear that investors remain very jittery, leaving traders unlikely to pile back into carry trades like the Japanese yen crosses. My long-term bias for the Japanese yen: bullish.

Terri Belkas is a Currency Strategist at FXCM.