US Dollar Rebounds Amidst Signs of Lingering Risk Aversion, Flip in Speculative Sentiment

The US dollar rebounded on Thursday, and there were hints of lingering risk aversion behind the move. Indeed, Standard & Poor’s downgraded their debt ratings outlook for General Electric from stable to negative, which will make it more difficult for the firm to raise money, and the news weighed heavily on US stocks, as the Dow Jones Industrial Average ended the day down 2.49 percent. Adding to this bearish sentiment, Chrysler announced that it was closing all its US manufacturing plants for at least a month as they and GM anxiously await signs that the government will step in and use TARP funding in order to save them. In fact, both auto makers have said that they won’t be able to pay all of their bills next month without assistance. However, the chances of Chrysler and GM becoming the Lehmans of the auto industry increase by the day, especially since the Bush administration said that it was considering facilitating an “orderly" bankruptcy of the firms. According to our latest FXCM Speculative Sentiment Index (SSI) readings, traders have grown increasingly long EUR/USD and GBP/USD, and as a contrarian indicator suggests the US dollar could rally further. From a fundamental perspective, this is certainly feasible if risk aversion returns as a dominant market-trend once again.

Japanese Yen: Bank of Japan May Cut Rates Overnight, Risks of Verbal and Physical Intervention

The Bank of Japan is widely expected to announce that they are leaving rates unchanged at 0.30 percent tonight. While there is no official time of release, we typically see the news hit the wires between 22:30 ET and 00:30 ET. There is potential for this to be very market-moving, not only because Credit Suisse overnight index swaps are pricing in a 56 percent chance of a 25bp cut, but also because of intervention risks. Indeed, given the rally in the Japanese yen over the past few months, Japanese exporters have felt the brunt of the impact, and the government has become increasingly concerned. In fact, they’ve started to use verbal intervention, as Finance Minister Shoichi Nakagawa said last night that he has “the means” to temper the appreciation of the yen. Japan has a long history of successfully intervening in the markets, as they hold the second largest amount of foreign currency reserves in the world (China holds the most). As a result, it will be important to watch for comments by the Bank of Japan pointing toward intervention, or perhaps even a physical one, in the near-term. Traders shouldn’t necessarily take this as a sign that they should sell yen, but should certainly beware of the potential for choppy price action if they are already holding positions.

Euro Pulls Back Sharply Against Greenback as ECB Cuts Deposit Rates, Raises Emergency Lending Costs

The euro and Swiss franc tumbled against the US dollar on Thursday as the European Central Bank cut the interest rate paid on bank deposits with the ECB overnight and increased its emergency lending rate. These moves were intended to prevent financial firms from hoarding cash and meant to push them to lend to each other and boost liquidity. The measures will go into effect after January 21, 2009, and it will be interesting to see what sort of impact this has on the markets, if at all. Indeed, the ECB is essentially betting that conditions have stabilized enough to allow the financial markets to operate on their own, but if this is not the case, the credit markets could feel the repercussions immediately. Until then, traders will be focused on the US dollar and outlooks for the ECB next rate decision on January 15. According to Credit Suisse overnight index swaps, the ECB will cut rates by at least 50bps to 2.00 percent, and these expectations could fuel additional declines in EUR/USD toward the 38.2 percent retracement level of 1.2549 - 1.4720 at 1.3891.

British Pound Plunges to Record Low Versus Euro, Swiss Franc

The British pound took a beating yet again on Thursday as the currency fell 3.5 percent against the US dollar and dropped over 2 percent versus the Swiss franc and euro to record lows. UK economic data was actually surprisingly strong, as retail sales rose for the first time in three months at a rate of 0.3 percent during the month of November. However, even the Bank of England has said in the past that they rely more on private surveys rather than government statistics, as they tend to be volatile and unreliable. It’s clear that forex traders have done the same, especially as the BOE is widely anticipated to continue cutting rates during the first half of 2009 in light of diminishing inflation and the first UK recession in 17 years. Barring another major sell off in the US dollar, there is potential for GBP/USD to drop back below 1.50 in the near-term.

Canadian Dollar Could Slump as CPI is Forecasted to Fall Below BOC's 2% Target

At 7:00 ET on Friday, Canadian CPI for November is anticipated to plunge 0.8 percent during the month while the annualized pace is forecasted to tumble to an 8-month low of 1.5 percent. Meanwhile, the Bank of Canada’s core CPI measure may slip to 1.6 percent from 1.7 percent. Given the sharp drop in commodity prices since the summer and slowing in the Canadian economy, there is potential for weaker-than-expected readings. This leaves some bearish potential open for the Canadian dollar, especially as a decline in CPI below the BOC’s 2 percent target would add to speculation that the bank will continue cutting interest rates. On the other hand, signs that price growth is not slowing in line with the BOC’s forecasts could push the Canadian dollar higher.

Terri Belkas is a Currency Strategist at FXCM.