US Dollar Ends Day Mixed, Could See Directional Moves on Releases of ISM Services, FOMC Minutes

The US dollar ended the day mixed across the majors once again, as the currency gained against the euro, Swiss franc, and Japanese yen but fell versus the British pound and the commodity dollars as oil rose toward $50/bbl. There were no market-moving indicators that influenced price action for the US dollar, but notable news included word that President-elect Barack Obama draft a plan to offer about $300 billion worth of tax cuts to individuals and businesses, which would account for about 40 percent of a stimulus package that has grown more than anticipated as it could reach $775 billion over two years. With evidence continuing to emerge that the US recession, which the National Bureau of Economic Research (NBER) has said started in December 2007, will likely extend through much of 2009, the new administration will do everything in their power to go down in history as the ones who saved the economy from falling into a situation akin to the Great Depression. Meanwhile, according to the Commerce Department, construction spending in the US during the month of November fell negative for the second month in a row at a rate of -0.6 percent. Looking at a breakdown of the report, it is clear that residential construction has weighed the overall index down significantly, as spending fell 4.1 percent during the month and plunged 22.8 percent from a year earlier. On the other hand, nonresidential construction spending actually rose 1 percent in November and remains up 9.2 percent from a year ago. Nevertheless, as businesses slowly feel the impact of the US recession, they will be far less likely to expand and build, leaving broad measures of construction spending likely to fall further.

The US dollar will see a pick up in event risk tomorrow. At 10:00 ET, a gauge of conditions in US non-manufacturing sector - which accounts for approximately 70 percent of total economic activity in the country and includes retail, services, and finance - is anticipated to have worsened in December as the ISM index is estimated to fall to another record low of 37.0 from 37.3. We already know that the US economy fell into recession long ago, but this data will help to gauge how long the recession will drag on for. A weaker-than-expected result could weigh on the US dollar, but the long-term impact should be limited since the Federal Reserve as already cut rates to a all-time low range of 0.0 percent - 0.25 percent and has few additional options from a traditional monetary policy perspective. The 14:00 ET release of the FOMC’s meeting minutes from December 16, when they slashed rates to a record low target range of 0.0 percent - 0.25 percent, should draw some attention, especially if they highlight the Committee’s plans to support the financial markets via measures that “sustain the size of the Federal Reserve's balance sheet at a high level.” Many have accepted this as an indication that the Fed is pursuing quantitative easing, and if it does seem that they will pursue buying “longer-term” Treasury securities, the US dollar could pull back as this would suggest that interest rates in the US will continue to fall.

Euro Tumbles on Dovish ECB Comments, Euro-zone CPI Could Exacerbate Sentiment on Tuesday

Last week’s consolidation in the euro versus the US dollar resolved itself this morning as EUR/USD broke below trendline and Fibonacci support at 1.3848 to settle above the next level of support at 1.3550 at the end of the day. The trigger for the move? Dovish comments by European Central Bank Vice President Lucas Papademos that suggested the ECB may indeed cut rates on January 15. Data released at 5:00 ET on Tuesday may confirm or negate this sentiment as Eurostat estimates for Euro-zone CPI are projected to show that inflation growth eased to a 1.8 percent pace in December from 2.1 percent. Given European Central Bank President Jean-Claude Trichet’s more bearish stance on economic growth and the bank’s total of 175 basis points worth of rate cuts since October, a weaker-than-expected CPI reading could exacerbate the market’s speculation that the central bank will cut rates again on January 15, and weigh on the euro. On the other hand, if CPI manages to hold at or above the ECB’s 2 percent target, the currency could gain as the markets assume the central bank will not be as quick to reduce rates.

British Pound Shows Signs of Life as Gilts Yields Rocket Higher

The British pound has spent most of December drifting toward support at 1.4400, as the markets anticipated that the Bank of England will continue cutting rates aggressively. This also led 2-year gilt yields to fall to record lows on Friday, but they made a comeback on Monday on speculation that the Bank of England will expand the 200 billion pound program that allows banks to buy illiquid securities in exchange for government debt. This seems feasible, as the minutes from the BOE’s December 3-4 meeting show that the Monetary Policy Committee though that the “Bank Rate was not the right policy instrument to tackle supply constraints in the credit market” and that additional “measures to underpin lending growth would be needed, building on the Government’s package announced in October to recapitalise and guarantee funding to the banks.” It will be important to gauge price action in the UK fixed income markets this week, as the rise in 2-year gilt yields by 7 basis points at 1.84 percent and jump in 10-year gilt yields of 12 basis points to 3.15 percent coincided with broad gains in the British pound. In fact, the currency gained more than 1 percent against the US dollar, 2.74 percent versus the Japanese yen, and over 3 percent against the euro and Swiss franc.

Of course, bearish risks linger for the British pound ahead of the BOE’s next rate decision on January 8 at 7:00 ET, as Bloomberg News is forecasting that the Bank of England will cut rates by 50 basis points, while Credit Suisse overnight index swaps are only pricing in a 25 basis point reduction. We already know that the UK economy is in recession and most expect it to get worse, but a rate cut seems even more likely when considering the latest study by the BOE. The BOE’s Credit Conditions Survey for the fourth quarter indicated that the situation had indeed deteriorated, with the availability of loans down despite unexpectedly stable demand for mortgages. Furthermore, the survey said that spreads on secured lending to households and on corporate lending had widened, while defaults on household and non-financial business loans had increased. However, the reaction of the British pound may depend on what sort of bias is reflected in the Monetary Policy Committee’s subsequent statement, because as we saw with the December 4 rate cut by the BOE, the currency could actually rise following a rate cut.

Terri Belkas is a Currency Strategist at FXCM.