US Dollar Response To US Recapitalization Plan Proves Lackluster - Why?

The US dollar ended the day lower versus most of the majors, though the bulk of the action came overnight in anticipation of the US government’s big recapitalization plan announcement. In fact, the greenback hardly budged during the NY trading session as the forex markets simply consolidated their larger moves. There are two topics to discuss: 1) what did the plan entail and 2) why didn’t it spark a US dollar rally? First, as part of the Troubled Asset Relief Program (TARP), the US Treasury will proceed with a "voluntary capital purchase program" where the US government will buy up to $250 billion in preferred shares from financial institutions at "attractive rates" for the US taxpayer. Institutions that sell shares will have to agree to restrictions on executive compensation, such as the golden parachutes that many corporate CEO's have received despite the underperformance of their firms. The hope is that once the markets stabilize and share prices rise, the taxpayer will actually make a profit. Meanwhile, the FDIC will guarantee the senior debt of all FDIC-insured institutions and their holding companies for 3 years, along with deposits in non-interest bearing deposit transaction accounts (such as basic business payroll checking accounts, which were not protected before). The goal? To allow financial institutions easier access to liquidity by boosting confidence in these banks, which should convince investors that it is safe enough to buy their debt and hold their deposits with the banks. Finally, the Federal Reserve also announced that its Commercial Paper Funding Facility (CPFF) program will fund purchases of commercial paper of 3 month maturity from high-quality issuers. The goal here is to allow the commercial paper markets, which have been frozen, to become functional once again.

Now, why didn’t the US dollar rally on all of this theoretically “good” news? Like the Japanese yen, the US dollar tends to gain during times of risk aversion, and conversely, has a tendency to fall when traders become more risk seeking and buy up carry trades. On Tuesday, however, we saw that most markets simply consolidated as volatility remained fairly high. In fact, the CBOE’s VIX Index ended the day very little changed from yesterday, suggesting that the US government’s actions have failed to completely alleviate investors fears. Looking ahead to Wednesday, US Advance Retail Sales are expected to fall for the third month in a row in September, with consensus forecasts by Bloomberg News calling for a 0.7 percent decline. According to the latest report from the International Council of Shopping Centers (ICSC), sales slowed to a 1.0 percent annual pace in September from 1.7 percent in August thanks to a pullback in spending on discretionary items such as apparel and furniture. Furthermore, spending at discount and wholesale clubs slowed as well, suggesting that deteriorating labor market conditions and plunging assets prices are taking a hefty toll on consumption patterns. Clearly, there’s quite a bit of downside risk for this particular report, with disappointing readings likely to lead the US dollar lower for at least a brief time.

British Pound Gains As UK CPI Rockets 5.2% - Will It Prevent the Bank of England From Cutting Rates Further?

The British pound jumped during the European trading session as UK inflation figures were stronger than expected, suggesting that the Bank of England may have little room to cut rates further in the near-term. In fact, the annual rate of UK CPI surged to 5.2 percent in September, the fastest pace in at least 11 years, as the measure has now held above the BOE’s 2 percent target for a year and above their 3 percent ceiling for 6 consecutive months. The September increase was led by electricity and gas costs, recreation, clothing and footwear. However, with the BOE more focused on the downside risks to growth and the possibility of recession, the CPI figures had little impact on interest rate expectations as Credit Suisse overnight index swaps are still pricing in nearly 125bps worth of rate cuts over the next 12 months. Looking ahead to Wednesday, UK jobless claims are forecasted to rise for the eighth consecutive month, suggesting that consumption in the nation is bound to slow even more through the end of the year. As a result, there is a bit of bearish potential for GBP/USD tomorrow morning, though any shift in risk trends may play a greater role in forex market price action going forward.

Euro Relatively Unfazed By Sharp Downturn In Investor Confidence - Will CPI Impact ECB Rate Expectations?

While the euro did back down from its morning highs near 1.3750, the currency ended the day up from yesterday despite dismal economic data. Indeed, German investor confidence turned extremely pessimistic in October amidst the crisis in the world’s financial markets, as the ZEW survey fell sharply to a reading of -63, just missing the all-time low of -63.9 from July. Nevertheless, as we saw with most of the majors, broad weakness in the US dollar stemming from risk-seeking activity proved to be the biggest driver of price action. Looking ahead to Wednesday, the September reading of Euro-zone CPI is expected to slip to 3.6 percent from 3.8 percent, but if this actually holds steady or falls less than forecasts, the euro could gain. The odds may be in favor of a more euro-bearish result though, as CPI could actually slip a bit more than anticipated, which would support the case for additional rate cuts by the ECB going forward. While the ECB has suggested that last week’s 50bp rate cut will not be the first of a series, it is clear that any actions by the ECB in the future will be to make monetary policy more accommodative.

Japanese Yen Trades Choppily As Volatility Fails To Cool

Despite aggressive intervention efforts by the US government, volatility remained relatively high on Tuesday which led to mixed trading in the Japanese yen crosses. The low-yielder fell versus most of the majors, including the high-yielding New Zealand dollar, British pound, euro, and Australian dollar. However, the bulk of the moves occurred during last night’s Asian trading session and with US stocks ultimately finishing the day lower, the Japanese yen crosses slumped at the end of NY trading. In the near-term, the Japanese yen could slip if traders become a bit more risk seeking. In the long-term though, my bias is bullish on the low-yielder, as significant perils loom for the financial markets given persistently tight credit conditions.

Terri Belkas is a Currency Strategist at FXCM.