US Dollar Brushes Off Dismal Consumer Confidence, Housing Starts - Rebound In Store Next Week?

The US dollar’s moves on Friday constituted little more than a broad consolidation across the majors as the currency hardly shifted from Thursday’s close. While there were some signs of stabilization in the markets, such as the drop in overnight interest rates, there were also indications that high volatility and lower liquidity leaves the markets prone to wild price swings. Indeed, the CBOE’s VIX Volatility Index continues to trade dangerously close to Thursday’s record high of 81.17 while the latest forex positioning report shows that open interest in pairs like EUR/USD and GBP/USD has been declining steadily, signaling lower liquidity. Overall, this leaves the notion of risk aversion in play, which tends to benefit the US dollar and explains why the currency was able to shrug off this morning’s disappointing economic releases. US housing starts and building permits both fell more than expected to nearly 18 year lows of 817K and 786K, respectively. This isn’t entirely surprising, as there is little reason to build new homes when there is already excess supply and limited demand. Meanwhile, the University of Michigan’s consumer confidence report fell by the most ever to a reading of 57.5 from 70.3, and while this is still above the June low, the index remains very close to its all-time low of 51.7 in May 1980.

Clearly the US economy is at risk of recession, and this is why fed fund futures are pricing in a 25bp-50bp rate cut on October 29. Under normal circumstances, this would contribute to US dollar weakness but with risk trends remaining the primary driver of the markets, safe-haven flows have supported the greenback quite a bit. Looking ahead to next week, this may remain the case as the only major piece of event risk comes from testimony by Federal Reserve Chairman Ben Bernanke on Monday at 10:00 EDT. Mr. Bernanke’s comments tend to be extremely market-moving, especially when it comes to the US dollar, Japanese yen, and stock markets. Given the jittery nature of the financial markets, traders may be quick to respond to any rhetoric signaling that the Federal Reserve will cut rates at the end of the month or comments suggesting that economic and financial conditions are bound to worsen.

Euro Hurt By Interest Rate Outlook, But Is It Bound to Recover?

The euro has remained weak due to a variety of factors, including broad US dollar strength due to safe-haven flows as well as negative interest rate expectations. In fact, Credit Suisse overnight index swaps continue to price in over 125bps worth of rate cuts by the European Central Bank over the next 12 months. While the annual rate of Euro-zone CPI growth is still well above the ECB’s 2 percent target, the measure has eased to 3.6 percent in September from a high of 4.0 percent in July, suggesting that inflation pressures in the region are cooling. 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. However, there are indications that the euro could rebound in the near-term. According to our latest forex positioning report, the FXCM Speculative Sentiment Index (SSI) has recently flipped from net long EUR/USD to net short, and as a contrarian indicator, suggests that the pair could gain. There is no major European data scheduled to be released next week, but if we see that volatility dies down a bit and equities gain, the EUR/USD retracement higher could come sooner rather than later.

British Pound: UK Fundamentals Remain Bearish, But Technicals Signal Potential Strength

The British pound finished the day on a slightly stronger note versus the US dollar, but the price action was really only part of a consolidation of GBP/USD between 1.7225 - 1.7385. Like the Euro-zone, prospects for the UK remain weak as the economy is likely headed for recession and as a result, the Bank of England is anticipated to cut rates by as many as 125bps over the next 12 months (according to Credit Suisse overnight index swaps). Nevertheless, with no market-moving data scheduled for release from the UK through the end of the week, technical factors may be the best gauge to use when it comes to GBP/USD. According to Technical Strategist Jamie Saettele’s Elliott Wave count, GBP/USD may be forming a bottom and according to Quantitative Analyst David Rodríguez, our Forex Trading Signals suggest Cable will break higher in the near term.

Carry Trades: Commodity Dollars Face Heavy Event Risk Next Week, Japanese Yen Struggles To Hold Onto Gains

Forex carry trades have seen exceptionally volatile price action lately, and while risky assets gained early during the US trading session, a drop in the DJIA at the end of the day cooled the rallies of the commodity dollars, including the Canadian, Australian and New Zealand dollars. Likewise, the Japanese yen crosses fell from their intraday highs as lingering risk aversion is preventing traders from piling back in to the once-lucrative trades. Looking ahead to next week, the Bank of Canada is widely expected to cut rates by at least 25bps on October 21, though a Bloomberg News survey shows that 10 of the 17 economists polled are betting they will slash rates by 50bps to 2.00 percent. The confusion comes from the fact the Bank of Canada (BOC) just cut rates on October 8 in a coordinated effort. However, the BOC’s October 8 press release and recent economic data suggests we could see something along the lines of a 25bp cut to 2.25 percent or no change. On October 22, consumption figures are expected to show that spending in fell flat in August, but excluding autos, retail sales are forecasted to have risen 0.3 percent. However, there is potential for a surprisingly strong reading given the solid employment numbers we’ve seen lately. Also on October 22, the Reserve Bank of New Zealand is anticipated cut rates by an incredible 100bps on October 22 to 6.50 percent. While inflation measures remain very high, the New Zealand economy has officially fallen into recession as GDP contracted for two consecutive quarters (-0.3 percent in Q1, -0.2 percent in Q2).

Terri Belkas is a Currency Strategist at FXCM.