US Dollar Plunges On Demand for Risky Assets - Will A Drop In ISM Non-Manufacturing Matter on Wednesday?

The US dollar pulled back sharply on Tuesday, especially against the high-yielding commodity dollars, amidst a pickup in demand for carry and an improvement in investor sentiment. While volatility remains relatively high, overnight interest rates have cooled down quite a bit, allowing the global stock markets to bounce higher. With the greenback being treated as a “safe haven” asset, it is this increase in risk appetite that is driving the currency lower. Will this move continue? That depends, again, on risk trends, but one thing we may be able to count on is disappointing US data on Wednesday.

Indeed, conditions in the US non-manufacturing sector - which accounts for approximately 70 percent of total economic activity in the country and includes retail, services, and finance - are anticipated to worsen in October as the Institute for Supply Management index is estimated to fall to a nine-month low of 47 from 50.2. There is also downside potential since confidence remains exceptionally weak, as the Conference Board’s measure fell to a record low of 38 during the same month. The key thing to watch is to see if ISM Non-Manufacturing falls below the 50 mark - signaling contraction - as the news will only add to bearish sentiment on the US economy following the 0.3 percent contraction in US Q3 GDP and the plunge in ISM Manufacturing to the lowest level since 1982. If the news spurs fears in the financial markets, leading stocks lower, the US dollar could actually gain amidst flight-to-quality. These days, negative US data counterintuitively tends to provide at least a short-term boost to greenback.

Euro Gains Nearly 3% Despite Signs the ECB Will Cut Rates Aggressively This Week

The euro rallied roughly 500 points trough to peak between Monday night and Tuesday afternoon to test 1.30, marking a nearly 3 percent gain. This was a strong move in every sense, but only highlighted how little fundamentals matter right now. This morning’s release of the Euro-zone producer price index would normally have a bearish impact on the euro, but instead, the currency completely ignored the news. Focusing on the release, the index slipped for the second consecutive month in September which dragged the annual rate of growth to a 4-month low of 7.9 percent from 8.5 percent. The bulk of the decline was due to weaker energy prices, which is in line with the steep drop we’ve seen in oil since late August. As a sign of cooling price pressures, this news suggests that the European Central Bank has room to make monetary policy more accommodative after participating in the October 8 coordinated rate cuts. In fact, according to a Bloomberg News poll of economists, the ECB is anticipated to reduce rates by 50bps to a 2-year low of 3.25 percent. This is similar to what Credit Suisse overnight index swaps are pricing in, though they also signal a small 19 percent chance of an unprecedented 75bp reduction. Looking ahead, EUR/USD may have a tough time breaking above resistance at 1.3027, but a bullish push could target the next level of resistance at 1.3136.

British Pound Rockets Higher, But 1.6100 Provides Formidable Resistance

Like the euro, the British pound rocketed nearly 500 points tough to peak between the Asian and US trading sessions, going so far as to test 1.6100. While the currency has since pulled back, support at 1.5912 has held GBP/USD afloat. Looking at the data on hand, nearly all economically-related news from the UK continues to point toward recession for the country as PMI Construction fell at the fastest pace in more than 10 years to 35.1 in October from 38.8. The prospects for the UK are so dismal that a Bloomberg News poll shows that economists are expecting the Bank of England to cut the Bank Rate anywhere between 50 and 100bps on Thursday from the current level of 4.50 percent. Credit Suisse overnight index swaps are fully pricing in a 50bp reduction along with an 80 percent chance of a 75bp cut. Given the BOE’s participation in the October 8 coordinated rate cuts, it’s fair to say that the central bank is likely somewhat panicked over what to do from monetary policy standpoint, and as a result, an aggressive 75-100bp cut is not out of the question. Looking ahead to Wednesday, UK industrial production numbers are likely to reflect a decline or stagnation in output for the seventh consecutive month, but as we saw this morning, fundamentals aren’t playing a big role in forex market price action and as a result, traders should keep a closer eye on risk trends and technical outlooks.

Carry Trades Rocket Higher, Benefiting the Australian Dollar While Killing the Japanese Yen

When you see a currency rally despite a sharp rate cut by its central bank, there’s a good chance you’re witnessing some sort of change in trend. Last night the Reserve Bank of Australia cut rates more than expected by 75bps to 5.25 percent, and as Currency Analyst Ilya Spivak pointed out, RBA Governor Glenn Stevens sounded ominous in the statement accompanying the decision, saying that "it appears likely that spending and activity will be weaker than earlier expected." This sort of commentary suggests that the RBA will continue cutting rates in coming months, yet, after a brief 100 point drop, AUD/USD rallied from 0.6600 to 0.7000 over the course of European and US trading. Why? Increased risk appetite. We witnessed this dynamic throughout the financial markets as risky assets like stocks and forex carry trades soared, while safe-havens and low-yielders like the US dollar and Japanese yen faltered. In fact, both the greenback and yen ended the day approximately 4 percent lower versus the high-yielding Australian dollar, and there is potential for this sentiment to feed through into the Asian trading session tonight. However, traders should beware as these moves could easily reverse on any signs of marked risk aversion.

Terri Belkas is a Currency Strategist at FXCM.