US Dollar Holds Strong Despite NBER’s Recession Confirmation, Bernanke’s Bearish Outlook

The US dollar ended the day higher versus most of the majors, but fell versus the currencies that tend to gain the most during times of risk aversion: the Swiss franc and Japanese yen. Indeed, the Dow Jones Industrial Average plunged 7.7 percent while the S&P 500 plummeted 8.93 percent, as the outlook for the global economy and financial markets remains bleak. Not only did ISM Manufacturing fall more than expected to the lowest level since 1982, but the National Bureau of Economic Research (NBER) also confirmed that the US fell into recession in December of 2007. The tone of the markets remained bearish as Federal Reserve Chairman Ben Bernanke said that economic conditions would “remain weak for a time” and while further rate cuts were “certainly feasible,” there may be little that the Fed can do with conventional monetary policy to alleviate persistently tight credit conditions and to lift the US out of recession.

Looking ahead to Tuesday, there are no major economic releases scheduled, but speeches by government and Federal Reserve officials can be just as market-moving for the US dollar and stock markets. At 11:30 ET, US Treasury Secretary Henry Paulson is due to speak on the US-China Strategic Economic Dialogue, which could provide some insight on future stimulus plans in the US and abroad. At 12:30 ET, Philadelphia Federal Reserve President Charles Plosser will speak on the economy. Regarding both Mr. Paulson and Mr. Plosser, comments that reflect information the markets are already aware of will not illicit much reaction, but if they issue dour outlooks for growth or suggest any new policies, volatility could increase rapidly.

Euro Remains Heavy, But 1.25 is the Level to Watch Ahead of Thursday’s European Central Bank (ECB) Rate Cut

The euro ended Monday consolidating above support at 1.26, but 1.25 - where there is intraday rising trendline support – provides a more significant level that will be worth watching, as a break below may be followed by a test of the October lows of 1.2328. Looking ahead, the Euro-zone's producer price index for the month of October is forecasted to fall negative for the third consecutive period at a rate of -0.3 percent, while the annual rate is anticipated to cool to 7.0 percent from 7.9 percent. Weaker commodity prices have helped to drive input costs lower, and when you take into account falling demand in the Euro-zone and abroad, producers are finding themselves with little in the way of pricing power. A decline in PPI in line with or more than expectations will only add to speculation that the European Central Bank will cut rates by at least 50 basis points on Thursday to a more than 2-year low of 2.75 percent, especially as last week's Euro-zone CPI estimates showed inflation falling back towards the ECB's 2.0 percent target.

British Pound Holds Above Support at 1.4805, Downside Risks Loom

After consolidating below 1.55 last week, the British pound plunged more than 400 points on Monday amidst mounting speculation that the Bank of England will cut rates aggressively on Thursday and as business activity in the UK manufacturing sector fell to a 16-year low. Manufacturing PMI tumbled to 34.4 in November from a downwardly revised 40.7 amidst major declines in new orders, despite weaker input costs, while employment showed similarly disappointing results. Meanwhile, the BOE reported that bank deposits but non-financial companies fell by the most since 1980 at a rate of 5.2 percent in October, while lending growth to these companies dropped 6.5 percent, down 17.9 percent from a year earlier. Just last week, BOE Governor Mervyn King said that the lack of availability of credit is one of the most worrying developments in the economy, suggesting the BOE may have a lot more work to do to loosen up the credit markets. Thus, Credit Suisse overnight index swaps are pricing in at least a 75bp cut by the central bank on Thursday, but there is potential for an even more severe move which leaves significant bearish potential open for the British pound going forward. That said, GBP/USD did manage to hold above support at 1.4805, signaling potential for a retracement higher in the near-term. However, a break below 1.48 is likely to be following by a test of the November 13 low of 1.4557.

Japanese Yen Strongest of the Majors as Risk Aversion Sends Dow Down 7.7%

The Japanese yen was the strongest of the major currencies we follow on Monday, as concerns about the future of the global economy and financial markets triggered deleveraging. Indeed, the yen ended the day up nearly 3 percent against the US dollar, euro, and Canadian dollar while rocketing close to 6 percent higher versus the British pound and New Zealand dollar. This coincided with a 7.7 percent plunge in the Dow Jones Industrial Average, highlighting the tight inverse correlation between the yen and US equity indexes.

Terri Belkas is a Currency Strategist at FXCM.