US Dollar Rally May Continue If Fed’s Bernanke Fails to Inspire Confidence on Tuesday

The US dollar continues to make headway higher, especially against the more volatile British pound and commodity dollars, as flight-to-quality leaves the “safe haven” greenback in demand. Indeed, there was very little in the way of major news, though the 1.46 percent drop in the Dow Jones Industrial Average, the more than 7.5 percent plunge in oil, and the 3 point rise in the CBOE’s VIX volatility index does add to evidence that risk aversion is still playing a role in setting trends for the financial markets.

On Tuesday, Federal Reserve Chairman Ben Bernanke is scheduled to speak in London at 08:00 ET on the financial crisis and policy response, and this could prove to be one of the biggest market-movers of the week due to its potential impact on investor sentiment. If Chairman Bernanke is bearish on prospects for the financial markets and global economy, his comments could have very negative repercussions for the stock markets, and we could subsequently see flight-to-quality spark demand for Treasuries, the US dollar, and Japanese yen. On the other hand, if he announces a new type of policy action or if he manages to inspire confidence that conditions will not get significantly worse, risky assets could rally.

Euro Teeters Above Support at 1.33 as Odds Remain in Favor of ECB Rate Cut This Week

The euro fell versus the US dollar and Japanese yen on Monday, but managed to hold up against the relatively weak British pound and commodity dollars. Focusing on EUR/USD, key support looms just below at the 61.8 percent retracement level of the rally from 1.2422-1.4720 at 1.3301, and with no key economic indicators due to be released from the Euro-zone over the next two days, it will be important to watch where price trades relative to support. Indeed, if EUR/USD breaks below 1.33, the pair will only find another layer of significant support at 1.2915 - 1.3000.

As I mentioned in the US dollar section, risk sentiment remains one of the bigger drivers of price action, so where EUR/USD goes from here may depend more on demand for safe-haven assets like the greenback. From a fundamental perspective, though, downside risks linger for the euro as the European Central Bank is expected to cut interest rates on January 15 by 50 basis points to 2.00 percent to match the 2005 record low. This easily leaves the 7:45 ET announcement as one of the most important pieces of event risk next week, but traders will also have to look out for comments by ECB President Jean-Claude Trichet during his post-meeting press conference at 8:30 ET. Mr. Trichet is one of the most opinionated central bank chiefs around, and suggestions that the ECB will continue to cut rates have the potential to lead the euro far lower. On the other hand, if the ECB goes the route of the BOE and signals that they may leave rates unchanged during their next meeting, the currency could actually rally.

British Pound Under Pressure as Risk Appetite Fades

The British pound has retraced more than 50 percent of the rally we saw last week, as lingering risk aversion weighs on some of the more volatile currencies. Meanwhile, the British pound also fell back against the euro, and further losses may be in store. This is naturally more in line with the fact that the Bank of England cut the Bank Rate to the lowest level since the bank was founded in 1694, but we also saw that while the Monetary Policy Committee’s (MPC) subsequent policy statement was quite bearish on economic conditions in the UK and abroad, they did not give any indication that they would cut rates again during their February 5 meeting. As it stands, actual rate cuts are having little impact on the currency markets, as traders are more focused on comparative long-term interest rate expectations and risk trends. There will be no key UK economic indicators released this week, making it all the more important to watch the latest return of risk aversion, which tends to work in favor of US dollar and Japanese yen strength.

Canadian, New Zealand, Australian Dollars the Weakest of the Majors as Oil Tumbles 7.5%

The commodity currencies - which include the Canadian dollar, New Zealand dollar, and Australian dollar – all fell back on Monday due to a variety of factors. Waning risk appetite sapped demand for carry trades, which hurt commodities like oil and higher-yielding currencies, while benefiting lower-yielding currencies, such as the Japanese yen and US dollar. Disappointing news from the Bank of Canada certainly did not help to prop the Canadian dollar higher either, as their Business Outlook Survey for Q4 showed that almost all indicators of sentiment fell to the their lowest levels since the survey began in 1997. Indeed, the survey reflected that firms expect sales growth to slow over the next 12 months, while sentiment on investment and employment has turned pessimistic, all of which suggests that the Canadian economy is in for a sharp slowdown, if not contraction, in coming months. Furthermore, inflation expectations for the next two years have declined "considerably" with commodity prices, and with a record number of firms reporting tighter credit conditions, the survey adds to evidence that the Bank of Canada will cut rates against on January 20. Looking ahead to the rest of the week, most of the event risk will be contained to the US dollar and euro, but on January 14, the Australian unemployment rate is anticipated to pick up to 4.5 percent from 4.4 percent while the net employment change is forecasted to fall negative for the second straight month by 20,000. The latter report tends to have a greater impact on the Aussie since the figure rarely meets expectations and can lead to volatile short-term price action for the Australian dollar immediately following the news at 19:30 EDT. The other important thing to watch is the status of risk, as an increase in market-wide volatility could send the commodity bloc diving lower.

Terri Belkas is a Currency Strategist at FXCM.