Euro Ends Day Modestly Lower as ECB Cuts Rates to Record Low of 2.00%, Leaves Door Open to Further Reductions

Trading throughout the forex markets was particularly volatile on Thursday as risk appetite shifted wildly. Meanwhile, the European Central Bank’s 50 basis point rate cut to a record low of 2.00 percent exacerbated moves for the euro, as the 7:45 ET reduction initially sent the currency plummeting. ECB President Jean-Claude Trichet’s 8:30 ET press conference subsequently sparked even more volatility, though. While there is another policy meeting scheduled in 3 weeks, Mr. Trichet said that the next "important" one will be in March when they release new projections for growth and inflation, suggesting they have no plans to adjust interest rates next month. However, he refused to call 2 percent the lower limit for interest rates, leaving the door open to further reductions in coming months. In the longer-term, Mr. Trichet indicated that inflation rates may rise against during the second half of 2009, but that it wasn’t necessarily relevant to rates as the Euro-zone is likely to experience a severe slowdown as global economic weakness weighs on export demand.

Looking ahead to Friday, the Euro-zone’s trade balance is forecasted to reflect a deficit for the seventh straight month in November, and may even widen to -4.8 billion euros (seasonally adjusted) from -1.3 billion euros in October. Exports face especially large downside risks as slowing foreign growth limits demand for European goods. However, imports have been weaker as well, especially given the decline in energy costs, which could help to prevent the balance from plummeting more than anticipated. This isn't typically a major market-mover for the euro, barring significant deviations from forecasts, but is nevertheless worth watching as a measure of the health of the Euro-zone's economy.

US Dollar, Japanese Yen Holds Inverse Correlation with DJIA as Risk Trends Dominate Price Action

Following a breakdown of correlations in December, the inverse link between currencies like the US dollar and Japanese yen and the Dow Jones Industrial Average has become tight once again. Indeed, intraday movements in the forex markets were in sync with those of the stock markets, as a roughly 2.5 percent drop in the DJIA at the start of the day translated into strength for the greenback and yen. However, once the DJIA moved back up into positive territory, the currencies pulled back across the majors. One factor that may have helped alleviate market fears of a government takeover of Citigroup was a comment by Federal Deposit Insurance Corp. (FDIC) Chairman Sheila Bair, who said that she would be “very surprised” if the government had to nationalize any large banks. This also helped to offset concerns that Bank of America will need more funding from the government in order to absorb losses stemming from their acquisition of Merrill Lynch.

There was also quite a bit of US economic data on hand as well at 8:30 ET. First, the Labor Department's US producer price index showed a 1.9 percent drop in costs during December due primarily to weaker energy prices, which compose 21.65 percent of the index and tumbled 9.3 percent. This led the annual rate of price growth down to a two year low of -0.9 percent, but core costs (excluding food and energy) actually rose 0.2 percent in December. Overall, the data does suggest that inflation is indeed moderating in the US thanks to the decline in commodity prices since the summer, but core prices may take a bit longer to cool. Meanwhile, initial jobless claims rose 11.5 percent to 524,000 for the week ended January 10. While this is down from the record high of 589,000 reached in the week ended December 19, it is still a very historically high number and suggests that job losses and the unemployment are sure to climb further in the New Year. Finally, the New York Fed's "Empire" manufacturing activity index edged slightly higher but remained negative for the ninth straight month at -22.2 in January. A breakdown of the index shows that every single component denoted a contraction, including prices paid/received, new orders, shipments, and number of employees. With both foreign and domestic demand slowing, manufacturers will remain at a great disadvantage going forward.

On Friday, the release of the December reading of the US Consumer Price Index (CPI) could lead the term “deflation” to be used abundantly in coming weeks and months (one that became very popular in November, according to Google Trends). Indeed, CPI is forecasted to have plunged 0.9 percent during December while the annual rate is anticipated to have fallen negative for the first time since 1955 by 0.2 percent. Excluding volatile food and energy prices, though, core CPI may have risen a slight 0.1 percent during the month, leaving the annual rate to edge down to a more than 4-year low of 1.9 percent from 2.0 percent. Overall, the news could weigh on the US dollar if CPI does indeed fall negative, but it may be more important to watch the impact of the data on investor sentiment, as increased risk aversion tends to benefit the US dollar and Japanese yen.

British Pound Consolidates Above 1.45 - Breakout Potential?

The British pound ended the day broadly higher on Thursday, thanks to a last-minute pickup in risk appetite that drove equities and carry trades higher at the very end of the US trading session. However, when looking at GBP/USD on intraday charts, the pair appears to be consolidated within a range of 1.4500 - 1.4670/1.4700, suggesting price may be bound to break either higher or lower in the near term. Which direction GBP/USD goes may depend most on risk trends, but the pair seems to be forming a bottom and leaves price more likely to break to the upside.

Terri Belkas is a Currency Strategist at FXCM.