Euro-US Dollar Surges on Bigger Than Expected Drop in US CPI, Only to Drop on Risk Aversion

The US dollar initially weakened versus the euro upon the release of US inflation figures, only to rebound in the afternoon as dim prospects for an auto industry bailout lead stocks lower and boosted demand for safe-haven assets. Looking at the data on hand, the Consumer Price Index (CPI) plunged 1 percent in October, marking the sharpest decline on record, while the core CPI, which excludes food and energy prices, unexpectedly fell for the first time since 1982. Overall, the figures suggest that the Federal Reserve has room to continue cutting interest rates, since the greatest risks for price growth are likely to the downside. The afternoon release of the minutes from the Federal Open Market Committee’s (FOMC) October 28-29 supported this outlook, as the Committee predicted that the economy will contract through mid-2009. Furthermore, some FOMC members “suggested that additional policy easing could well be appropriate at future meetings,” and that they “agreed to take whatever steps were necessary to support the recovery.'' As a result, fed fund futures are signaling more aggressive rate cuts during the Federal Reserve’s December meeting, as they are fully pricing in a cut from 1.00 percent to 0.50 percent, and a 20 percent chance of a cut to 0.25 percent.

Economic data due to be released on Thursday may exacerbate this sentiment, as initial jobless claims are forecasted to hold near 7-year highs of 505K while continuing jobless claims are expected to rise to a fresh 26-year high of 3900K. Increasing claims for unemployment benefits are bound to push the unemployment rate higher, which is already at a 14-year high of 6.5 percent. Later in the morning, the Federal Reserve Bank of Philadelphia's index of business activity is expected to rise very slightly to a reading of -35 from an 18-year low of -37.5 in October. Nevertheless, a reading below zero still suggests that the manufacturing sector is contracting, and given the drop in the New York Fed's "Empire" manufacturing index to a record low during the same period, there is little hope that the Philly Fed report will be surprisingly strong. Overall, this data should work in favor of additional dollar strength, as disappointing reports tend to spark flight-to-quality.

British Pound Spikes Amidst Wild Volatility, Falls Back as BOE Minutes Signal Further Rate Cuts

The British pound gained throughout much of the morning to reach an intraday high of 1.5249, but subsequently fell back below 1.50 as UK interest rate expectations remain in favor of GBP/USD weakness. The earlier gains in the pair were surprising given the contents of the Bank of England’s Monetary Policy Committee meeting minutes from November, which were released at 4:30 ET. The MPC was quite bearish on prospects for the UK economy and financial markets, while they also noted the projections from their latest Inflation Report, which showed CPI falling sharply in the near-term and below the BOE’s 2.0 percent target in 2009. The part that was most surprising, though, was that the MPC discussed cutting rates by more than 200bps before voting unanimously to reduce the Bank Rate by 150bps to a 53-year low of 3.00 percent. This only added to speculation that the BOE would continue reducing rates, and Credit Swiss overnight index swaps are nearly pricing in a 75bp cut during their next meeting in December. Looking ahead to Thursday, the release of UK Retail Sales is expected to show that consumer spending fell 0.9 percent in October, dragging the annual rate to a nearly 2-year low of 1.4 percent. The latest BRC retail sales numbers support the case for such a move, as their measure of same-store sales plunged 2.2 percent in October from a year earlier. However, this is not always the most reliable leading indicator, and the BOE has said in the past that they may focus more on private surveys over government statistics, as the latter tends to be extremely volatile. As a result, traders should keep in mind that regardless of this upcoming number, the BOE likely still holds a bearish view of UK consumer spending.

Japanese Yen Jumps While US Stocks Close at Lowest Levels Since March 2003

The Japanese yen has traded very choppily lately, but remains below its October 24 highs where the low-yielding currency ran into critical resistance versus most of the majors. However, given the drop in US shares on Wednesday that led the Dow Jones Industrial Average and S&P 500 to close at the lower levels since March 2003, it may only be a matter of time before we see the yen test the October highs once again. Indeed, investor sentiment has been the key trend we’ve been following in the forex markets, as bouts of risk aversion that lead equities lower tend to benefit the Japanese yen. According to our latest forex correlations report, the correlation between USD/JPY and the Dow is near the highest levels in at least 20 years, and with stocks likely to fall even lower, the outlook suggests the Japanese yen could gain much more. In economic news, the markets are likely to start paying a bit more attention to the Bank of Japan's rate decision following their surprise 20bp rate cut last month. The BOJ’s Monetary Policy Committee will meet overnight, and while no decision is scheduled to be announced until late Thursday night, they are likely to leave rates unchanged. However, it will be important to get a sense of what the Committee expects for growth and inflation going forward. Bearish investors are betting that many central banks will move towards Zero Interest Rate Policy (ZIRP) in coming months, a policy Japan implemented in the 1990's and essentially stuck with until July 2006. With Japanese interest rates already extremely low at 0.3 percent, the BOJ would logically be the first to get there once again.

Terri Belkas is a Currency Strategist at FXCM.