US Dollar, Japanese Yen Dominate as RBS Woes Weigh on Risk Appetite

The US stock markets were closed on Monday for the Martin Luther King, Jr. holiday, but that doesn’t mean that risk aversion couldn’t feed through from Europe into US trading. Indeed, Monday’s most exciting price action was contained to the European trading session, as news that the Royal Bank of Scotland may report the biggest recorded annual loss in UK corporate history sparked a bout of selling in stocks and heavy buying in the US dollar and Japanese yen. In fact, both the greenback and the yen ended the day up over 1 percent against the euro and nearly 2 percent versus the British pound. With no data due to be released from the US on Tuesday, the outlook for safe-aven currencies and carry trades depends heavily on risk trends.

British Pound Declines Could Continue as UK CPI is Forecasted to Drop by Most in 7 Years

Risks for the UK economy and financial markets remain high as the Royal Bank of Scotland (RBS) said that they may report the biggest recorded annual loss in UK corporate history, amounting to as much as 28 billion pounds. The news led European equities and the British pound to tumble lower as it remains clear that the banking sector is far from stable, even after the UK government enacted a 50 billion pound recapitalization plan in October. As a result, UK Prime Minister Gordon Brown has announced another bank rescue package which will give the Bank of England (BOE) the power to lend up to 50 billion pounds directly to businesses, and the UK Treasury has agreed to swap its RBS investment of 5 billion pounds in preference shares - which provide dividends - for ordinary shares. All in all, the move could bring the government’s stake in RBS up from roughly 58 percent to 70 percent.

Looking ahead to Tuesday, UK data is forecasted to reflect a sharp drop in inflation pressures, which should allow the BOE additional leeway to cut rates this year. The Consumer Price Index (CPI) for the month of December is expected to drop 0.9 percent - the most in seven years - dragging the annual rate down to 2.6 percent. Likewise, the core measure, which excludes volatile food, energy, alcohol, and tobacco costs, is anticipated to fall to an annual rate of 1.3 percent from 2.0 percent. If CPI cools more than forecasted the GBP/USD could pull back toward falling trendline support at 1.4300/50, especially since the BOE suggested in their last policy statement that they may leave rates unchanged next month. On the other hand, indications that price pressures are not falling sufficiently could lead the British pound to gain.

Euro Falls Sharply as S&P Downgrades Spain’s Credit Rating, European Commission Forecasts Sharp Drop in Growth in 2009

The euro fell more than 1 percent against the US dollar on Monday amidst deteriorating investor confidence and dour forecasts by the European Commission. The Commission said that the Euro-zone’s economy will contract by 1.9 percent in 2009, which would mark the first negative result since the inception of the euro, before growing by 0.4 percent in 2010. Furthermore, the unemployment rate is anticipated to climb from 7.5 percent to 9.3 percent in 2009 and 10.2 percent in 2010. Finally, inflation pressures are likely to cool substantially as CPI is expected to fall from 3.3 percent in 2009 to 1 percent in 2009, following by a pickup to 1.8 percent in 2010. Nevertheless, it is clear that some regions are suffering more than others as S&P lowered Spain’s long-term sovereign credit rating to AA+ from AAA, citing “expectations that public finances will suffer in tandem with the expected decline in Spain's growth prospects, and that the policy response may be insufficient to effectively counter the related economic and fiscal challenges.” This downgrade will make it more expensive for the country to borrow and thus, more difficult to invest in measures meant to boost the economy, and also highlights one of the major problems associated with monetary unions: monetary policy is not always going to suit the economies of all participants.

Looking ahead to Tuesday, the German ZEW survey of investor sentiment is forecasted to show a slight improvement in opinion on the economic outlook, but a continued deterioration in confidence in the current situation. This is similar to what we saw with the US Reuters/University of Michigan consumer confidence index, which reflected a rise in the economic outlook as the government is likely to come to agreement on a fiscal stimulus plan amounting to $825 billion within weeks. The ZEW survey doesn’t tend to be a huge market-mover for the euro on a long-term basis, but can have a very short-term impact and as a result, remains an indicator worth watching.

Canadian Dollar Outlook Depends Not on Bank of Canada’s Rate Decision, but Press Release Policy Bias

The Canadian dollar could see a pickup in volatility on Tuesday at 9:00 ET as the Bank of Canada is widely expected to cut interest rates for the fourth time since October. A Bloomberg News poll of economists reflects consensus forecasts for a 50 basis point cut to 1.00 percent, but as of Friday, Credit Suisse overnight index swaps were pricing in a slight chance of a 75 basis point cut to 0.75 percent. As it stands, economic conditions deteriorated rather rapidly in December, as the Canadian unemployment rate rose to a nearly 3-year high of 6.6 percent while Ivey PMI fell to a record low of 39.1, marking the second straight month that the indicator signaled a contraction in business activity. Likewise, surveys published by the BOC reflected bleak scenarios for both sales and the credit markets, suggesting the central bank will cut rates to at least 1.00 percent. However, as we so often see when it comes to rate decisions, the Canadian dollar’s reaction may hinge more upon the policy bias contained within the Bank’s concurrent press release. Any indications that they may leave rates unchanged at their next meeting in order to await more data could send the Canadian dollar spiraling higher.

Terri Belkas is a Currency Strategist at FXCM.