US Dollar Outlook Hinges Upon Federal Reserve Rate Decision Next Week - What Will They Do?

The US dollar was mixed across the majors on Friday, slipping against the euro and Japanese yen while gaining versus the British pound and commodity dollars. The US Senate’s failure to pass an auto bailout plan has left considerable uncertainty in the financial markets, especially as General Motors (GM) has already hired bankruptcy counsel. The White House subsequently stepped in on Friday morning to express disappointment about the bailout’s failure, and to say that they were considering other options, including using TARP funding in order to salvage the plan. Until the Treasury makes this official, though, the markets will likely bet on the bankruptcy of automakers like GM and Chrysler.

There was additional dollar-bearish news lingering in the markets as well, as US consumption contracted for the fifth straight month in November, highlighting the extent of the recession in the US. Indeed, the Commerce Department reported that advance retail sales fell 1.8 percent during the month, and while spending is anticipated to remain lackluster through year-end and 2009, there is a notable factor we must take into account that is skewing this report: prices. This particular index is not adjusted for inflation, and because gas costs have fallen precipitously in recent months, the Commerce Department's reading shows a 14.7 percent plunge in gasoline station sales. However, looking at the rest of the report, electronics, furniture, clothing, sporting goods, and general merchandise sales all rose slightly during November. That said, this is likely a result of heavy discounting and promotions by retailers during the holiday shopping season, which should extend through December. Once we get into the New Year, though, traders should watch these components as they will provide a good gauge as to the status of the consumer and how long the recession will last.

Overall, the news still leaves the odds in favor of an aggressive rate cut by the Federal Reserve next week. In fact, on December 16 at 14:15 ET, the Fed is widely anticipated to announce a 50bp cut to the fed funds rate, which would bring the rate to 0.50 percent. However, this is actually on the lower end of what the markets are expecting, as fed fund futures are pricing in a 72 percent chance of a 75bp cut to 0.25 percent. This upcoming monetary policy decision will be extremely important not only because of the prospect of such historically low rates, but also because the FOMC’s policy statement may signal that they are done cutting rates, or may suggest that they are prepared to pursue unconventional options like quantitative easing. The news could have major consequences for the US dollar and risk trends in general, meaning that the Japanese yen crosses may experience significant volatility as well.

British Pound Hits Fresh Record Low Versus Euro, BOE Meeting Minutes May Make or Break Cable Next Week

The British pound slumped against the US dollar and plunged to fresh record lows against the euro on Friday, as the outlook for the UK economy remains bleak. As we mentioned yesterday, conditions in the Euro-zone are by no means strong, but they are comparatively better than in the UK as the credit crunch has choked off the finance sector that has previously allowed the country to thrive for so long. Going forward, the Bank of England is anticipated to continue cutting rates aggressively, as BOE Governor Mervyn King has declined to rule out cutting rates to zero in the past. This leaves the release of the minutes from the BOE’s December meeting on December 17 all the more important. During the December meeting, the BOE’s Monetary Policy Committee slashed the Bank Rate by 100bps to 2.00 percent, as expected. The key will be to gauge the vote count, as indications that the decision to cut rates was unanimous and clear discussion of additional rate cuts in the future could lead the British pound to pull back sharply.

Japanese Yen Hits 13-Year High Versus Dollar, Treasury to Announce TARP-Funded Auto Bailout on Sunday?

The Japanese yen held its own on Friday as lingering risk aversion sent the currency to 13 year highs against the US dollar overnight, as Japan announced an emergency economic package. Indeed, the country pledged 4,000 billion yen in spending and tax cuts and 3,000 billion yen in credit for companies, along with an increase in limits for public fund injections for financial institutions to 12,000 billion yen. However, risk aversion was a bigger driver of the move, as Japanese fundamentals rarely play a role in Japanese yen price action, with the biggest issue on the minds of traders being the failure of the US Senate to pass an auto bailout plan overnight. While the White House has suggested that they may step in and use TARP funds in order to salvage the plan, a confirmation by the Treasury will be necessary to revive investor confidence. As we’ve seen in the past, the US government has a long history of making these sorts of announcements on Sunday, so it may be worthwhile to check out the news before forex trading resumes on Sunday afternoon. Other risk-related news includes Ecuador’s default on “illegal” foreign debt and Japan’s announcement of an emergency economic package, as the country pledged 4,000 billion yen in spending and tax cuts and 3,000 billion yen in credit for companies, along with an increase in limits for public fund injections for financial institutions to 12,000 billion yen.

Other news to watch includes the release of the Bank of Japan's Tankan survey on Sunday evening, which is expected to show that confidence amongst Japan's large manufacturers fell by the most since 1975 during Q4, as the index is forecasted to fall to -23 from -3. The outlook amongst manufacturers and non-manufacturers alike is expected to be similarly gloomy, as the combination of waning foreign and domestic demand proves to be toxic for Japanese businesses. Exporters have faced particularly difficult circumstances given the 16% jump in the Japanese yen against the US dollar over the past six months. The appreciation of the Japanese yen has been even more extreme against other currencies over the same time period, as it has rallied 27% versus the euro, 35% against the British pound, 38% versus the New Zealand dollar, and 40% against the Australian dollar. In light of this situation, speculation is mounting that the Bank of Japan will move to intervene in the currency markets in order to stem the Japanese yen's gains. If the results of the Tankan survey prove to be disappointing, the chances of intervention will likely rise.

Terri Belkas is a Currency Strategist at FXCM.