US Dollar, Japanese Yen Surge as Risk Aversion Triggers 4% Decline in DJIA, Jump in Volatility

While many people were watching the inauguration of President Barack Obama, equity traders were focused on the sharpest drop in State Street Corp’s shares since 1984 as the world’s largest money manager for institutions reported a doubling in unrealized bond losses. With the exception of a few weeks in December, the US dollar and Japanese yen have both been driven primarily by risk appetite since mid-2008, as flight-to-safety and deleveraging work to strengthen the currencies. As a result, we must credit the gains in the greenback and the yen on Tuesday to lingering risk aversion, which was only exacerbated by State Street’s losses, as we also saw the Dow Jones Industrial Average end the day down a whopping 4.01 percent while the CBOE’s VIX volatility index surged higher. Over the next 24 hours, news that may impact risk trends will generally remain contained to the stock markets, as a variety of S&P 500 companies will be issuing earnings releases, including banks like Northern Trust and computer powerhouse Apple.

British Pound Tumbles as Core CPI Hits 2 Year Low, BOE’s King Forecasts ‘Marked’ Contraction in H1 2009

The UK consumer price index contracted for the third straight month in December at a rate of 0.4 percent, helping to drag the annual rate down to 3.1 percent from 4.1 percent. The index’s decline was far less than expected, as the annual rate was actually forecasted to plunge to 2.6 percent, and the actual rate leaves inflation well above the BOE’s 2 percent inflation target and just above their 3 percent ceiling. However, the core measure of CPI, which excludes volatile food, energy, alcohol, and tobacco costs, plunged to a more than 2-year low of 1.1 percent from 2.2 percent, suggesting that broad price pressures are indeed cooling. This leaves the odds in favor of further reductions to the UK’s Bank Rate, especially as BOE Governor Mervyn King said in a speech this afternoon that the contraction of GDP during the first half of 2009 may be “marked” and there was is still potential for inflation to fall below 2 percent. Mr. King also left the door open to the use of “unconventional” measures, and that in coming weeks, the BOE may purchase securities such as corporate bonds and commercial paper in an effort to boost liquidity and lending to companies and consumers.

Not all is said and done when it comes to gauging the BOE’s policy bias going forward, though, as the minutes from the Monetary Policy Committee’s (MPC) meetings tend to be a huge market-mover for the British pound upon release at 4:30 ET, and this Wednesday’s announcement is unlikely to be any different. During the January meeting, the MPC slashed the Bank Rate by 50 basis points to a record low of 1.50 percent, as expected. However, the British pound subsequently rallied as the MPC did not give any indication that they would cut rates again during their February 5 meeting. The British pound’s response to the release of the minutes will depend on if the MPC’s comments and outlooks signal the same thing: that the BOE will hold a more neutral stance going forward. If, on the other hand, the MPC seems to hold a more dovish stance, the British pound could pull back sharply.

Euro Tumbles Despite Slight Improvement in Investor Sentiment, France’s Auto Industry Bailout

The euro continues to tumble within a falling wedge formation, and ended the day trading just above trendline support at 1.2875. Economic data from the Euro-zone hasn’t helped the currency very much, especially since the EUR/USD and EUR/JPY pairs in particular have been weighed down by deleveraging and flight to quality. Looking at the European data on hand for the day, while the ZEW survey showed that German investor sentiment on current conditions remained dismal during January, confidence in the economic outlook was better than expected as the index rose to -31 from -45.2. This increase marked the third improvement in a row, following four rate cuts by the European Central Bank since October and the announcement of a 50 billion euro stimulus plan by German Chancellor Angela Merkel last week. Meanwhile, French Prime Minister François Fillon said that the government would set aside 5 - 6 billion euros worth of loans for the French auto industry, primarily for Renault and PSA Peugeot Citroën, though the plan would still need the approval of the European Commission. Over the next 24 hours, there will be no key economic indicators released, but with risk trends still the dominant driver of price action in the forex markets, it is necessary to keep an eye on the stock markets and volatility gauges, since risk aversion works in favor of US dollar strength and thus, euro weakness. As mentioned above, immediate support looms at 1.2875, but additional support at a rising trendline connecting the October and November lows may come into play at 1.2600/25.

Canadian Dollar Continues to Slip as Bank of Canada Slashes Rates to Record Low of 1.00%, May Cut Further

The Canadian dollar ultimately ended the day lower against the US dollar after the Bank of Canada cut rates in line with expectations by 50 basis points to 1.00 percent, which marks the lowest level since the bank was founded in 1934. Meanwhile, the bank's concurrent press release left the door open for further rate cuts as they said that further monetary stimulus may be needed since total CPI is expected to fall negative for two quarters in 2009 due to falling energy costs while Canada's economy is forecasted to contract through mid-2009. However, the bank also said that they would continue monitoring "economic and financial developments" in order to judge how to reach their 2 percent inflation target "over the medium", suggesting they may not be rushing to slash rates again in March if data between now and then signals that inflation pressures are actually holding up. This leaves Friday's Canadian CPI report all the more critical to Canadian dollar price action later this week.

Terri Belkas is a Currency Strategist at FXCM.