US Dollar Still the Safe Haven of Choice, Providing It with Bullish Potential

The US dollar gained nearly 1.5 percent versus the British pound and almost 2 percent against the euro, and as usual, this was primarily the result of flight-to-quality. In fact, the dollar’s biggest push for the day came just as the DJIA and S&P 500 started the day off on a weak note, plummeting approximately 2 percent right at the market open. These forex correlations shouldn’t be ignored, as they are directly related to the risk trends that are essentially driving price action throughout the financial markets. While credit conditions have improved quite a bit over the past two weeks or so and the CBOE’s VIX volatility index remains well below the record highs achieved on October 27, there is lingering uncertainty about the health of the financial markets as there is a still a major lack of transparency. In fact, just yesterday Bloomberg News filed a lawsuit against the Federal Reserve to disclose the securities the central bank is accepting as collateral for its $1.5 trillion worth of loans to banks. Furthermore, there is growing concern about the health of emerging market economies, as Fitch Ratings downgraded the long-term foreign currency ratings of South Korea, Mexico, Russia and South Africa to negative from stable due to the “profound deterioration” in the global outlook and the continued credit crunch. This is the same dynamic we’ve seen in the markets for weeks, as evidenced by the dismal US employment data we saw on Friday and its minimal impact on the greenback. Thus, I think it may be more beneficial to keep an eye on risk trends and data from regions like the Euro-zone and UK. Ultimately, the trend for the greenback remains bullish, but the currency could experience sharp pullbacks during times that risky assets, such as equities and commodities, surge.

Euro Likely to Remain Under Pressure as Data Points Toward Aggressive ECB Rate Cuts

The euro fell sharply at the start of the US trading session thanks following the release of less-than-impressive data out of the Euro-zone. Furthermore, a sharp drop in US stocks signaled persistent risk aversion in the markets, which typically benefits only low-yielders like the US dollar and Japanese yen. European economic data was mixed, but generally remained supportive of expectations that the European Central Bank would continue to cut rates aggressively through year-end and 2009. In fact, Credit Suisse overnight index swaps are fully pricing in a 25 basis point by the ECB during their next meeting on December 4, and are pricing in 94.5 basis points worth of reductions over the next 12 months. Looking at the indicators on hand, the German wholesale price index fell for the third straight month in October, dragging the annual rate to a more than one-year low of 3.6 percent. Given the steady slide in commodity prices since July, global price pressures have eased quite a bit and government inflation statistics, such as the German wholesale price index, have started to reflect this and Friday’s Euro-zone CPI numbers will likely do this as well. Meanwhile, the highly watched German ZEW survey of investor sentiment surprisingly showed a slight improvement in economic expectations, though the index measuring confidence in the current economic situation tumbled to a three-year low of -50.4. The big market-mover of the week for the euro won’t come until Friday, when the above-mentioned CPI report is released, though this may be overshadowed by the first round of Euro-zone Q3 GDP figures. Indeed, GDP is anticipated to contract for the second consecutive quarter, fitting one of the broader definitions of recession and essentially guaranteeing more aggressive rate cuts by the ECB. Thus, these economic reports create significant bearish potential for the euro which leaves the long-term trend very much in play.

British Pound Could Break Below 1.53 If BOE Quarterly Inflation Report Cites Deflation Risk

The British pound remains firmly within in a downtrend, and despite the correction higher we saw during the last days of October, it may only be a matter of time before GBP/USD breaks below the October 24 low of 1.5257. Dismal outlooks for the UK economy and interest rates are likely to continue weighing the currency down, as Credit Suisse overnight index swaps are fully pricing in a 25 basis point rate cut by the Bank of England in December and 71.9 basis points worth of cuts over the next 12 months. Part of the reason for this is the weak status of the UK housing sector, as evidenced most recently by the 5.1 percent drop in the DCLG house price index in September from a year earlier. Indeed, the index reading was the lowest since record-keeping began in 2003 and given the persistent tightness of the credit markets, more stringent lending standards, and rising unemployment, things are likely to get worse. Upcoming economic data on Wednesday could highlight this as jobless claims in the UK are anticipated to rise for the ninth consecutive month in October by 40K, the largest single-month gain since 1992. While this could impact the British pound upon release at 4:30 ET, the announcement of the Bank of England’s Quarterly Inflation Report at 5:30 ET may be more important. Given the BOE’s latest policy statement following their aggressive 150 basis point rate cut, it appears that the Monetary Policy Committee is now more concerned about the potential for deflation, and if the Inflation Report confirms this outlook, the news could trigger a large British pound sell-off.

Japanese Yen Gains as US Stock Markets Tumble 2%, Highlighting Strong Inverse Correlation

The USD/JPY pair hardly moved on Tuesday, but this was not indicative of broader Japanese yen trends as the low-yielder rose roughly 2 percent against the British pound, euro, and Australian dollar. As we discussed in the US dollar section, risk trends remain the primary driver of the financial markets, which is likely to continue benefiting low yielding currencies like the yen and dollar, while high-yielding currencies like the Australian dollar and New Zealand dollar may be prone to the sharpest declines.

Terri Belkas is a Currency Strategist at FXCM.