US Dollar Gains On Risk Aversion, Will Weak US Consumer Confidence Finally Cool the Rally?

The US dollar rallied across the majors during the European trading session, but subsequently pulled back later in the day despite stronger-than-expected US economic data. Indeed, the Commerce Department reported that US new home sales rose 2.7 percent in September from a month earlier to an annual rate of 464,000. Looking at a breakdown of the report, supply levels eased to 10.4 months from 11.4 months while median prices dropped 9.1 percent from a year earlier to $218,400, suggesting that the lower values are encouraging buying. However, with credit conditions remaining stringent, it may be difficult for homebuyers to get mortgages. Combining that with the deterioration in the labor markets and clear economic slowdown in the US, and the outlook for the housing sector doesn’t look good. Thus, I’m a bit skeptical of this “positive” report and wouldn’t go so far as to call it an indication of a bottom. Instead, I think residential investment will continue to create a drag on the economy, which should be reflected in Thursday’s Q3 US GDP figures.

Looking ahead to Tuesday, the release of US economic data may highlight some of the reasons why most believe the country is in midst of a recession. Indeed, at 9:00 ET, the August reading of the S&P/Case-Schiller index of home prices is likely to fall by 16.6 percent from a year earlier, marking yet another record decline. Later in the morning at 10:00 ET, the Conference Board’s consumer confidence index is forecasted to drop to 52.0 in October from 59.8. While this would still be above the June low, it would be a historically dismal number as the record low from December 1974 looms at 43.2 (records go back to 1967). These economic releases have the potential to weigh on the US dollar, as they will add to speculation that the Federal Reserve will cut rates sharply on October 29. However, if risk trends continue to dominate the markets, the greenback may brush off the data and gain on flight-to-safety.

Euro Dives to Lowest Level Since April 2006 as ECB President Trichet Signals Rate Cut Next Week

The euro fell to the lowest level since April 2006 against the US dollar on Monday as European Central Bank President Jean-Claude Trichet signaled that the ECB may cut rates on November 6. During a speech in Spain, the outspoken Trichet said, “I consider it possible that the Governing Council would decrease interest rates once again at its next meeting.” Given this commentary along with indications of cooling inflation pressures and slowing growth, Credit Suisse overnight index swaps are now pricing in 129.2 basis points worth of rate cuts by the ECB over the next 12 months, compared to 117.3 basis points on Friday and 88.9 basis points at the beginning of the month. The potential for lower interest rates presents further downside risks for the euro, especially as Tuesday’s GfK consumer confidence report for Germany is anticipated to fall to yet another record low of 1.5 from 1.8.

British Pound Dives to 6-Year Lows on Carry Trade Declines

The British pound remains extremely weak across the majors as it has a few factors working against it: 1) it is not a safe-haven like the US dollar or Swiss franc 2) it is not a low-yielder like the Japanese yen and 3) last week’s Q3 GDP figures confirmed that the country is in recession. Instead, due to the relatively high interest rates maintained by the Bank of England (e.g. 4.50 percent in the UK versus 1.5 percent in the US), the British pound get hits particularly hard when carry trades selloff in general. When you also consider the Credit Suisse overnight index swaps are pricing in nearly 200 basis points worth of rate cuts by the BOE over the next 12 months, it’s clear that there is still bearish potential for the currency. Looking ahead to tomorrow, CBI Distributive Trades may reveal negative sales yet again, especially since PMI manufacturing for the UK has held below 50 (signaling contraction) for five consecutive months.

Carry Trades: Japan Suggests Yen Intervention Is On the Way, Australia Proves It Doesn’t Always Work

Forex carry trades sold off sharply on Monday, as the Japanese yen surged more than 4 percent versus high-yielding currencies like the New Zealand dollar and Australian dollar, while gaining 1.5 percent - 3 percent against the US dollar, euro, and Canadian dollar. Indeed, risk aversion is still intact as the CBOE’s VIX Index remains near its record high of 89.53 from Friday at 80, leaving the odds in favor of Japanese yen strength. However, the low-yielder’s resilience was somewhat surprising given comments from the G7 over the weekend suggesting intervention may be on the way, as the statement expressed concern about “the recent excessive volatility in the exchange rate of the yen and its possible adverse implications for economic and financial stability.” However, the Reserve Bank of Australia has shown that intervention doesn’t always work, as they said they have been trying to do so for the past three days, and yet the Australian dollar has still fallen nearly 12 percent against the greenback and almost 18 percent versus the Japanese yen. Since the currency market is among the most liquid in the world, it would take a significant amount of capital to be able to move the market when the trend is moving in one direction and there is little demand for carry trades. As a result, Japan is unlikely to attempt any sort of major intervention effort until volatility dies down and the markets stabilize.

Terri Belkas is a Currency Strategist at FXCM.