US Dollar, Japanese Yen Remain Strong as DJIA Tumbles 2.94%, Retail Sales Plunge

The US dollar and Japanese yen remained strong on Wednesday as risk aversion remains a very real theme in the markets. The biggest piece of evidence of this: increased demand for Treasuries, the 2.94 percent drop in the Dow Jones Industrial Average, and the nearly 6 point rise in the CBOE’s VIX volatility index. Meanwhile, the release of the US Advance Retail Sales index proved to be even worse than expected, as it fell 2.7 percent during the month of December alone. This marked the sixth straight month of contraction and the worst string of declines since recordkeeping began in 1992, but is particularly negative because the holiday shopping season is supposed to be a boon for retailers, but even the most aggressive discounting wasn’t able to offset the impact of a deteriorating labor market, tighter credit conditions, and a year-long recession. With job losses continuing to climb, the dismal retail sales results may be just a part of a rather consistent trend through the first half of 2009.

Going forward, risk trends may continue to determine price action for both the US dollar and Japanese yen, as we’ve seen that at this point, fundamentals have little impact on the currencies. Throughout the day on Thursday, multiple members of the Federal Open Market Committee (FOMC) will be speaking on the economy and monetary policy, including Atlanta Fed President Dennis Lockhart, Chicago Fed President Charles Evans, and San Francisco Fed President. Comments by FOMC members tend to be very market-moving, especially when it comes to interest rate expectations, so traders should keep an eye on the news wires as they could have negative or positive implications for risk sentiment.

Euro Down Ahead of ECB Rate Decision, But Could EUR/USD Ultimately Rally in Response?

The euro slipped for yet another day versus the US dollar and Japanese yen, as a combination of risk aversion and speculation of a rate cut by the European Central Bank (ECB) on Thursday morning weighs on the currency. According to Credit Suisse overnight index swaps and a Bloomberg News poll of economists, the ECB is likely to cut interest rates by 50 basis points to match the 2005 record low of 2.00 percent. This easily leaves the 7:45 ET announcement as one of the most important pieces of event risk this 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, a more probable scenario is 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.

Canadian Dollar, New Zealand Dollar, Australian Dollar All Tumble on Deleveraging, Risk Aversion

The commodity currencies - which include the Canadian dollar, New Zealand dollar, and Australian dollar – all fell back yet again on Wednesday, and as I mentioned in the US dollar section, increased demand for Treasuries, the 2.94 percent drop in the Dow Jones Industrial Average, and the nearly 6 point rise in the CBOE’s VIX volatility index suggest that risk aversion is in play. The Australian dollar faces even more bearish potential overnight as 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 ET.

British Pound Gains Across the Majors as British PM Brown Announced Loan Guarantees

The British pound was actually the strongest of the major currencies we follow, beating out the “safe haven” US dollar and even the Japanese yen, which tends to benefit the most from increased volatility in the markets. What gives? The British pound has been, by far, one of the most unpredictable currencies as its dynamics against the euro have been as closely followed as the GBP/USD pair. EUR/GBP is currently consolidating above 0.90, and where the pair goes next may have a lot to do with the euro’s broad response to the ECB’s rate decision on Thursday morning. Working in the British pound’s favor on Wednesday, though, was a pledge by UK Prime Minister Gordon Brown to guarantee 21.3 billion pounds worth of loans to companies in an effort to force banks to lend. This comes in addition to the previously announced 50 billion-pound bank recapitalization program and takeover of the Royal Bank of Scotland. This is generally in line with the sentiment of Federal Reserve Chairman Ben Bernanke’s speech yesterday, in which he noted that more capital injections, guarantees, and efforts to remove toxic assets off the books of financial institutions would be needed to ensure financial stability in the long term.

Terri Belkas is a Currency Strategist at FXCM.