US Dollar Down and Out Ahead of FOMC Decision - What to Expect

The US dollar tumbled on Monday as the New York Fed's "Empire" manufacturing index fell to yet another record low in December of -25.76 from -25.43. Looking at a breakdown of the report, the price components (prices paid, prices received) all declined, supporting the argument that inflation is no longer a concern. Meanwhile, the components measuring new orders, shipments, and number of employees all remained negative, pointing to waning demand and a continued deterioration in the labor markets.

With economic data signaling easing price pressures and economic contraction, there is little doubt that the Federal Reserve will announce a rate cut on Tuesday at 14:15 ET. As it stands, the Fed is widely anticipated to announce a 50bp cut to the fed funds rate, which would bring the rate down 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 66 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 Continues to Reach New Lows vs Euro, UK CPI Could Weigh on GBP/USD

The British pound rocketed over 300 points higher versus the US dollar on Monday morning, but it was not enough to keep the currency from reaching record lows against the euro for the third consecutive trading day. Prospects for the British pound remain bleak, as the economy tips into recession led partially by the collapse of the once-flourishing financial sector. Looking ahead to tomorrow morning, the UK Consumer Price Index (CPI) is expected to fall negative for the second straight month and may bring the annual rate down to 3.9 percent from 4.5 percent. However, given the plunge in commodity prices in recent months along with waning domestic demand, there is a possibility that CPI could fall even more than expected. As a result, the news could weigh on the British pound, especially against the euro, as the markets will continue to price in further rate cuts by the Bank of England in coming months. On the other hand, indications that inflation pressures are not falling quickly enough could lead the currency higher.

Euro Surges Nearly 2.5%, Yet the Euro-zone’s Economic Outlook Remains Bleak

The euro jumped more than 2 percent against the US dollar and hit a fresh record high versus the British pound on Monday, but that isn’t to say the outlook for the Euro-zone is optimistic. Indeed, according to the European Central Bank’s Monthly Bulletin for December, Eurosystem staff project that average annual real GDP growth will be between 0.8 percent and 1.2 percent in 2008, between -1.0 percent and 0.0 percent in 2009 and between 0.5 percent and 1.5 percent in 2010. Likewise, inflation is anticipated to slow further with overall HICP projected to be between 3.2 percent and 3.4 percent in 2008, between 1.1 percent and 1.7 percent in 2009 and between 1.5 percent and 2.1 percent in 2010. This is much of the reason why Credit Suisse overnight index swaps are fully pricing in a 25bp cut by the European Central Bank during their next meeting on January 15 and over 100bps worth of reductions during the next 12 months. None of this has stopped the euro from making headway, though, and the EUR/USD pair could be headed for a test of resistance at the 9/11 low of 1.3880. At this juncture, the extensive EUR/USD declines from mid-July though October were bound to experience some sort of bullish retracement, and with FXCM Speculative Sentiment Index showing that traders are net short the pair, this contrarian indicator signals further gains.

Terri Belkas is a Currency Strategist at FXCM.