US Dollar Gains Despite Dismal ISM Manufacturing - Why?

The US dollar gained against currencies like the euro and British pound amidst a more than 5 percent drop in oil. Indeed, the drop in energy prices and signs of lingering risk aversion, such as the rise in demand for gold and US Treasuries, all worked in favor of US dollar strength. Meanwhile, the release of US economic data only added to evidence that risk trends are driving the forex markets rather than fundamentals, as the ISM manufacturing index fell more than expected to a reading of 38.9 in October from 43. This was not only the third consecutive month that the index held below 50 - signaling a contraction in business activity - but was also the worst overall reading since 1982. It is becoming increasingly obvious to even the most fervent optimist that the US economy is in the midst of recession, and according to Dallas Fed President Richard Fisher, expansion in the US may stagnate completely through 2009. However, with interest rates in the US already historically low at 1 percent, there is little that the Federal Reserve will be able to do from a monetary policy perspective to revive growth. This is likely much of the reason why Mr. Fisher noted that there will be a “significant role" for fiscal policy going forward. Nevertheless, fed fund futures are still pricing in a 25-50bp cut by the Federal Reserve during their next meeting on December 16. That said, the US dollar is essentially in consolidation mode following its massive multi-month rally that started in mid-July, but the long-term trend remains in favor of dollar strength as risk aversion is unlikely to truly fade anytime soon.

Euro Tumbles as Risk Appetite Remains in the Driver’s Seat, But European Fundamentals Aren’t Helping Either

The euro took a hit on Monday thanks to persistent risk aversion in the markets, but we also have to consider the fact that the fundamentals of the Euro-zone are extremely bearish. Things are so bad that the European Commission today that the region probably entered a recession this year, and may stagnate completely in 2009. Given European Central Bank President Jean-Claude Trichet’s already-bearish stance on economic growth and the bank’s participation in the October 8 coordinated rate cuts, this news has only added to market speculation that the ECB will cut rates this week on November 6. Credit Suisse overnight index swaps are fully pricing in a 50bp reduction, and in the run-up to this meeting, we could easily see the currency continue to tumble throughout the week.

British Pound Remains Heavy As Markets Anticipate 50-100bp BOE Rate Cut This Week

The British pound plunged throughout the day on Monday, and support at 1.5800/12 may not be able to hold the currency back from further declines as the long-term trend remains very much in favor of GBP/USD weakness. Indeed, looking at the latest UK data, PMI manufacturing for the month of October rose slightly to 41.5 from 41.2, but the more important factor was that the index held below 50 - signaling a contraction in business activity – for the sixth consecutive month. There are few that don’t believe the UK economy is in the midst of recession, and as a result, traders are generally expecting the Bank of England to take aggressive action on Thursday. A Bloomberg News poll of economists shows consensus estimates of a 50bp cut to 4.00 percent. However, as time goes on, it seems more likely that we’ll see something along the lines of a 75-100bp reduction. In fact, dovish comments issued by Bank of England Monetary Policy Committee member David Blanchflower last week indicated that UK interest rates may be lowered “significantly” and “quickly.”

Carry Trades: How Will the Australian Dollar Respond to the Reserve Bank of Australia’s Rate Decision?

The Australian dollar faces particularly big event risk tonight as the Reserve Bank of Australia is anticipated to cut rates by 50bps to 5.50 percent. This would be the third consecutive reduction and would bring the cash rate target down to more than two-year low, but traders should also take into account the potential for a surprise factor. Credit Suisse overnight index swaps are fully pricing in a 50bp move, but are also pricing in a 38 percent chance of a 75bp cut. The RBA is known for being extremely aggressive at times, as evidenced by their 100bp decrease in October, so there is a chance they could make such a move. However, traders should also watch the subsequent monetary policy statement from RBA Governor Glenn Stevens as this may ultimately decide the Australian dollar’s fate. Using last month’s RBNZ rate decision as an example, the central bank cut rates sharply, but because RBNZ Governor Alan Bollard’s statement suggested that future reductions would be data-dependent, the New Zealand dollar actually held up (but plummeted the following day). As a result, if we see that Mr. Stevens indicates that the RBA could leave rates unchanged during their next meeting, the Australian dollar may hold its own. On the other hand, signs that the RBA will make monetary policy significantly more accommodative in coming months could weigh the Aussie down toward 0.6500/50.

Terri Belkas is a Currency Strategist at FXCM.