US Dollar Ignores Dismal Retail Sales, Rallies Amidst Flight-to-Safety

Despite all of the issues facing the US economy, we’ve seen that the US dollar continues to gain on safe haven flows, similar to what we see with gold and US Treasuries. While the Federal Reserve has stepped up their liquidity injection efforts by offering unlimited amounts of dollar funding in conjunction with the European Central Bank, Bank of England, Swiss National Bank, and Bank of Japan, there is still a huge amount of demand. As a result, it may be worth questioning what sort of benefit these liquidity efforts serve when banks are simply hoarding cash anyway as they avoid lending in fear of unknown counterparty risk. Indeed, volatility is still remarkably high, and while the CBOE’s VIX Index is down from Friday’s record high of 76.94 near 69, its levels suggest that market sentiment remains firmly risk averse.

This helps to explain why the greenback is holding strong despite dismal US data. Indeed, Advance Retail Sales fell sharply during the month of September at a rate of 1.2 percent, marking the worst result since August 2005 and the third consecutive negative reading. A 3.8 percent slump in auto sales contributed the most to the decline amidst a combination of high gas prices and waning demand for durable, expensive goods. Overall, though, the decline is indicative of a trend that will prove to be detrimental for broad economic growth. Furthermore, with most of the other G10 nations experiencing a major economic slowdown as well, US exports - the lynchpin of expansion in Q2 - are likely to weigh heavily on US growth through the end of the year. That said, US fundamentals have not been remotely market-moving for the US dollar, and this will likely remain the case until risk aversion stops being the dominant driver of price action throughout the financial markets. Check out our outlook for Thursday’s release of the US Consumer Price Index.

Euro Dives Lower as Odds Remain In Favor Of ECB Rate Cuts

Following a European session rally, the euro fell throughout US trading amidst broad safe-haven flows to the greenback. Focusing on European fundamentals, it is becoming increasingly clear why Credit Suisse overnight index swaps are pricing in over 125bps worth of rate cuts by the European Central Bank over the next 12 months. The annual rate of Euro-zone CPI growth eased to 3.6 percent in September from 3.8 percent, suggesting that inflation pressures in the region are cooling. Though CPI is still well above the ECB’s 2 percent target, the fact that we’ve seen commodity prices fall sharply eliminates much of the upside risks the central bank was so concerned about previously. Furthermore, with economic growth slowing quite a bit in the region and the credit crisis taking a toll on European financial markets, the ECB has turned their attention away from inflation and onto recession risks.

British Pound Plunges from 1.76 as Markets Price In 125bps Worth of BOE Rate Cuts

The British pound was strong versus the US dollar during the European trading, but subsequently fell over 200 points throughout the afternoon as the greenback surged and jittery investors sold off risky assets. Looking at the data on hand from the UK, there was little reason for traders to buy Cable from a fundamental perspective. Indeed, jobless claims rose for the eighth consecutive month by 31.8K in September to 939.9K, the highest level since November 2006. The deterioration in the labor markets is both an indication of gloomy outlooks by employers as well as a signal that UK recession risks loom large as consumption may contract significantly in coming months. As a result, the Bank of England is expected to cut rates multiple times over the course of the next year, despite the fact UK CPI remains well above the BOE’s 2 percent target at 5.2 percent, as the central bank will be willing to bet that the economic slowdown will cool inflation pressures on their own. The prospects for rate cuts should be enough to weigh on GBP/USD, but unfortunately for those that like to trade based on fundamentals, price action in the forex markets continues to be driven by risk trends.

Japanese Yen Dominates the Forex Markets As Investors Remain Risk Aversion

Despite aggressive intervention efforts by the US government on Monday, volatility remained relatively high as the CBOE’s VIX Index crept toward last Friday’s record high. There’s little doubt investors remain fearful as indicated by the surge in the Japanese yen across the majors, the plunge in US stock markets (the S&P 500 fell over 9 percent), and rising demand for safe-havens like Treasuries and gold. In fact, the low-yielding yen rallied nearly 3 percent against the British pound and Euro while rocketing 7 percent higher versus the Australian dollar. It is clear that traders are staying clear of carry trades, and with investor sentiment unlikely to improve substantially anytime soon, my long-term bias remains bullish on the Japanese yen.

Terri Belkas is a Currency Strategist at FXCM.