US Dollar Dives on Federal Reserve’s Aggressive Rate Cut, Teetering Above Key Support

The US dollar plummeted across the majors on Tuesday as the Federal Reserve cut the fed funds rate more than expected, while signaling that interest rates will stay low for “some time.” Prior to the announcement, the markets had been anticipating a 50bp cut, but instead, the Fed delivered a 75bp reduction to bring the fed funds rate down to a target range of 0.0 percent - 0.25 percent. This unprecedented move led the greenback to experience its biggest 5-day drop since the inception of the euro in 1999, according to Bloomberg News, especially as the Fed said they would consider introducing quantitative easing by purchasing longer-term Treasury securities, which would essentially drive down longer-term interest rates. Overall, the Fed’s action have opened up significant bearish potential for the US dollar, especially as the latest UK CPI figures show inflation pressures holding relatively strong while European Central Bank officials have suggested they want to avoid cutting rates any lower than 2 percent. The key thing to watch, though, is for renewed indications that the Bank of England and European Central Bank will be equally aggressive in cutting rates or pursuing new monetary policy options, as the prospect of declining interest rates in other regions could lead to a rebound in the greenback. Though something like this may not occur for weeks, in the near-term, traders should also keep in mind that the US dollar index has run into support at the 50 percent retracement level of 71.31 - 88.40 at 79.85. Thus, the currency could see a bit of a bounce in coming days following Tuesday’s extensive declines.

British Pound Outlook May Hinge on the Bank of England’s December Meeting Minutes

The UK consumer price index (CPI) fell less than expected during the month of November at a rate of -0.1 percent, while the annual rate eased to 4.1 percent from 4.5 percent. While this is still well above the Bank of England’s 2.0 percent target, BOE Governor Mervyn King said this morning that CPI will likely meet it during the first half of 2009, but fall “materially below it later in the year,” and perhaps even below 1 percent. Mr. King also said that the Monetary Policy Committee (MPC) will “continue to take whatever actions are required to ensure that the outlook for inflation remains in line with the Government's 2 percent target.” Looking ahead to the next 24 hours, the minutes from the BOE’s December policy meeting will provide one of the best gauges of where interest rates will go next. During this meeting, the BOE’s Monetary Policy Committee slashed the Bank Rate by 100bps to 2.00 percent, as expected. The key will be to watch the vote count, as a unanimous decision to cut rates and indications that the MPC sees the need for additional rate cuts in the future could lead the British pound to pull back sharply. However, traders should also beware that UK jobless claims will hit the wires at the same time, and they could exacerbate any bearish impact on the British pound from the minutes as claims are forecasted to rise for the tenth straight month and by the most since December 1992.

Euro: How Will Euro-zone CPI Influence the European Central Bank in January?

The euro shrugged off a spate of disappointing economic releases and instead continued its rally throughout the US trading session thanks to unexpectedly aggressive monetary policy actions by the Federal Reserve. Looking at the data on hand, the Euro-zone’s composite measure of manufacturing and services sector activity fell below 50 – signaling a contraction in business activity – for the seventh straight month as PMI tumbled to a record low of 38.3. The data suggests that the recession plaguing the region will linger as we enter 2009, but will the European Central Bank continue to cut rates? Last week, ECB Governing Council member Axel Weber indicated that he didn’t want the central bank to cut rates any lower than 2.00 percent, but with the ECB’s benchmark rate already at a historically low 2.50 percent, this doesn’t leave much room for maneuver from a traditional monetary policy perspective. An upcoming release from the Euro-zone may help determine if the ECB will use what few options they have in January, as Wednesday’s CPI report is anticipated to show that inflation pressures fell significantly during November. Indeed, CPI is projected to drop 0.5 percent from the month earlier, which may drag the annual rate down to a 1-year low of 2.1 percent from 3.2 percent. Such a decline would add to speculation that the ECB will continue cutting rates, and could weigh on the euro. However, if we see that CPI does not fall in line with expectations, the euro could rally as traders will speculate that the ECB will stop short of cutting rates again in January in order to await confirmation of easing price pressures. From a technical perspective, a long-term trendline that supported the EUR/USD rally from 2002-2008 now serves as resistance at approximately 1.4150. Thus, the pair may be more inclined to pull back from Tuesday’s highs through the end of the week.

Carry Trades Rocket Higher as DJIA Rallies 4.2%, USD/JPY Falls Below 90

Carry trades were in demand today as the high-yielding Australian and New Zealand dollars surged against the greenback and Japanese yen. So why did USD/JPY fall below 90? The first thing to consider is that US interest rates are now lower than Japanese interest rates, but traders should also keep in mind that the greenback was the currency with the fundamental driver behind it. To a certain degree, there is less of an argument for the Bank of Japan to step in and intervene in the currency markets based on the Japanese yen’s gains against the US dollar alone, as the former actually fell versus most of the majors, including the euro and British pound, on Tuesday. However, if the Japanese yen rally accelerates on a broader basis, the risks of intervention will increase. Looking ahead to Wednesday, traders should keep in mind that the Organization of the Petroleum Exporting Countries (OPEC) will be meeting. As a commodity currency, the Australian dollar holds a solid correlation with oil (0.74 over the past 20 days). Since OPEC is anticipated to announce a sharp cut in production, a surge in oil could subsequently trigger a rally for the Australian dollar. For more on this, check out our Australian Dollar Forecast.

Terri Belkas is a Currency Strategist at FXCM.