US Dollar Still the Safe-Haven of Choice – More Gains in Store?

Despite dismal fundamentals, the US dollar rally continues to dominate as it remains one of the strongest currencies, second only to the Japanese yen. The Federal Reserve is still struggling to stabilize the markets as banks remain worried about counterparty risk and are avoiding lending. As a result, the Fed said they would raise the interest rate paid on bank reserve balances in an attempt to keep liquidity in the financial system without impacting their monetary policy.

For all intents and purposes, the Fed is having little impact and risk aversion rules theUS stock markets spiraled lower, with the DJIA closing down over 500 points. Likewise, US Treasuries surged on flight to quality while the CBOE’s VIX volatility index jumped back up to 69.65 from 53.11. Though the VIX is below last Friday’s record of 70.33, it is still at historically high levels as anything above 40 was once a rare event. With volatility unlikely to die down anytime soon, it isn’t really worth it to try to fight the long-term dollar bullish trend. Indeed, given the drop in gold - a classic safe-haven asset - it appears that price action throughout the financial markets constitutes deleveraging and mass movements to cash.

Euro, British Pound Remain Under Pressure on Negative Outlooks from IMF, BOE’s King

The British pound and continued their freefall on Wednesday, as GBP/USD stabilized above 1.6150 while EUR/USD tested 1.2750. Most of the declines actually came during the Asian trading session as risk aversion remained the predominant sentiment in the markets, leading anti-dollar trades like the euro and British pound along with Japan’s stock markets lower. In fact, the Nikkei 225 ended the day down 6.79 percent while the Topix plunged a whopping 7.05 percent. The major news for Europe came a few hours later, though, with the most shocking revelation coming from Bank of England Governor Mervyn King who said the UK economy was likely headed for recession. This was followed by the release of the minutes from the Bank of England’s October 8 meeting, which showed that the 50bp cut to 4.50 percent implemented that day was by a unanimous vote. Given the substantial downside risks to growth, persistence of the credit crunch, and broad dovish bias amongst the BOE’s Monetary Policy Committee members, it is clear that the central bank will be cutting rates multiple times in coming months, and in fact, Credit Suisse overnight index swaps are pricing in nearly 175bp worth of reductions during the next year.

Meanwhile, a damning outlook from the International Monetary Fund (IMF) spurred fears about the Euro-zone’s financial sector. In its October 2008 Regional Economic Outlook for Europe, the IMF warned that more European banks could fail “as implied by their very high risk spreads and market doubts about the viability of their business models.” With a recovery not expected until late 2009, the European Central Bank (ECB) may be forced to make monetary policy significantly more accommodative going forward. Though the ECB is not anticipated to cut rates at their next meeting on November 6, Credit Suisse overnight index swaps are pricing in over 100bps worth of reductions over the next 12 months. Taking into account the dovish prospects for the UK and Euro-zone there are obvious downside risks for the British pound and euro, and until risk aversion starts to fade, these currencies will continue to have bearish potential.

New Zealand Dollar, Australian Dollar Show Signs of Bottoming

Commodity dollars like the Canadian dollar and New Zealand dollar slipped for much of Wednesday’s trading session, but the latter saw a surprising bounce following the Reserve Bank of New Zealand’s (RBNZ) rate decision. Indeed, the RBNZ slashed their Overnight Cash Rate (OCR) target by 100bps to 6.50 percent, which is the sharpest cut since the OCR was introduced in March 1999. This move was in line with expectations, and though RBNZ Governor Bollard said that he expects rates will be lowered further, the New Zealand dollar gained. Why? A closer look at the policy statement shows that Mr. Bollard also suggested that rates could be left steady at their next policy meeting, as he said that further cuts depend on "evidence of actual reductions in domestic cost pressures as well as how the global financial developments play out." Furthermore, during a post-meeting press conference, Mr. Bollard said future rate cuts "won't necessarily be of this size." As a result, the markets are betting that the RBNZ will await additional data before making monetary policy more accommodative, and will do so at a slower pace. This decision may have a major impact on currencies going forward, as the RBNZ has essentially thrown a wrench in the market’s expectations that interest rates would be cut aggressively in coming months by central banks with high overnight lending rates. If we see the New Zealand dollar gain overnight, there will be reason to believe that it may have formed at least a short-term bottom. Since the New Zealand dollar and Australian dollar hold a very tight correlation, this would also bode well for Aussie.

Japanese Yen Remains Unstoppable as Volatility Surges

The Japanese yen was easily the strongest currency in the markets on Wednesday, as a lingering risk aversion and a surge in volatility (as measured by the VIX Index) led to broad selloffs in the equity and commodity markets. In fact, even gold - a classic safe-haven asset - plummeted over $50/oz, suggesting these market declines constitute deleveraging and mass movements to cash. As usual, this sentiment led the low-yielding yen to rocket higher across the majors, gaining nearly 3 percent against the US dollar and Aussie, and more than 5 percent against the British pound, Kiwi, and Loonie. Overall, it will take a serious recovery in investor sentiment, or at least a bounce in the stock markets, before the Japanese yen will start to give up some of these massive gains. That said, with EUR/JPY trading near its November 2003 lows and GBP/JPY hitting the lowest levels since 2000, traders should be wary of trying to buy back into carry trades. We may be nearing a bottom for pairs like these, but it would be more prudent to await clear signs of a reversal.

Terri Belkas is a Currency Strategist at FXCM.