US Dollar: Will We See A Reversal Early Next Week?

Flight-to-safety triggered major gains for the US dollar on Friday, as volatility remained exceptionally high in the market. In fact, the CBOE’s VIX Index surged to a record high as Moody’s Investors Service said that they may cut their rating on Morgan Stanley, stoking already-high anxiety amongst traders about the health of financial and serving to create the perfect storm to spur selling in the equity markets. Indeed, S&P 500 experienced its worst week since 1933 and the DJIA had its worst week ever, and given these massive losses, the New York Stock Exchange and Nasdaq Stock Market will reportedly try to impose a temporary ban on short sales for individual stocks that falls at least 20 percent for the following three days. As usual, these solutions are very short-sighted, and may not be beneficial in the long-term. The issue is trust between counterparties, and banks are simply hoarding cash because they don’t know if the banks they’d normally lend to will be the next to fail. Trust needs to be restored before the markets can recover, and many will be looking toward the Group of Seven nations to help improve this.

Indeed, the G7 met today in Washington, but one official said that they were unlikely to adopt a commitment to guarantee loans between banks, like the UK has done. Meanwhile, there are concerns that any statement the G7 makes will not be sufficiently strong to restore confidence in the markets, as Italian Prime Minister Giulio Tremonti refused to endorse a draft, saying that it was “too weak.” As a result, these may leave Sunday’s meeting of European Union leaders in Paris as a more important event. Since the start of September, Sunday has been one of the most important days in terms of financial market news. The announcements that Fannie Mae and Freddie Mac were being nationalized, that Merrill Lynch would be sold to Bank of America, and that Lehman was teetering on the brink of bankruptcy all fell on a Sunday. The pressure is on, but if the G7 or EU comes out with a statement that leads the credit and stock markets to stabilize a bit, the US dollar could see a sharp reversal lower.

Euro Plummets On Fears G7 Will Not Find Solution

The euro hit the lowest levels in over a year before finally hitting support at the 6/13/07 low of 1.3263. Indeed, fears of a financial market meltdown drove the US dollar higher across the majors as the G7 failing to announce significant commentary during the day. In fact, the only news regarding the G7 meeting was generally negative, with Italian Finance Minister Giulio Tremonti refusing to endorse a draft statement, saying that it was “too weak.” Meanwhile, comments by Italian President Silvio Berlusconi saying that they discussed “suspending the markets for the time it takes to rewrite the rules” sent stock markets diving lower. Mr. Berlusconi later rescinded his statement, saying he didn’t mean it, but the reaction of the markets highlights how incredibly important it is for official to issue a strong statement or plan in the near-term. As a result, a meeting of European Union members on Sunday will be key to where EUR/USD goes next. Given the sharp reversal in EUR/USD from 1.3260 on Friday, I think there’s some bullish potential for the pair early next week, unless the G7 and European Union meetings fail to yield anything that boosts investor sentiment.

British Pound Consolidates Massive Losses - Recovery in Store?

The British pound held to a range of 1.6900 - 1.7150 on Friday, holding up fairly well versus the dollar compared to currencies like the euro, which plunged. For once, the UK is looking to be somewhat ahead of the curve as they have enacted aggressive policies meant to stabilize the markets. Though it did not prevent the FTSE 100 from falling, as the index closed down 8.85 percent, the UK government announced plans on Wednesday for a 50 billion pound strategy to partly nationalize at least eight British banks. Furthermore, UK Chancellor of the Exchequer Alistair Darling proposed that nations should guarantee lending between banks, either by turning central banks into clearing houses for the loans or having governments back them. The suggestion has not been ruled out by Treasury Secretary Henry Paulson, which may signal that the plan could actually be enacted. Next week on October 14, the September reading of the UK Consumer Price Index is forecasted to accelerate to an annual rate of 5.0 percent from 4.7 percent, as is also anticipated by the Bank of England. While these expectations did not stop them from cutting rates on October 8 by 50bps to 4.50 percent in a coordinated effort with central banks like the Federal Reserve, European Central Bank, and Bank of Canada, among others, stronger than expected CPI results could lead the British pound could rise. On the other hand, a weaker than forecasted result could weigh on the currency.

Japanese Yen Consolidates Gains on Choppy Day In Stock Markets

The Japanese yen gained quite a bit during the Asian trading session, but simply consolidated for much of the European and US trading session, suggesting the currency may be a bit overbought. Indeed, volatility was extreme by every measure, as the VIX hit its highest level on record. The predominant issue in the markets right now is the severe lack of confidence in the markets, and that is why the billions of dollars in liquidity injections by the world’s central banks haven’t really made a dent in deteriorating credit conditions. 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. However, if we see some sort of announcement over the weekend saying that governments will guarantee bank lending, the Japanese yen could fall back.

Terri Belkas is a Currency Strategist at FXCM.