US Dollar, Japanese Yen Gain as US GDP Figures Push the DJIA Down to Critical 8,000 Level

The US dollar and Japanese yen remained in demand on Friday, second only to the British pound, as US economic data fueled risk aversion in the markets and actually led the Dow Jones Industrial Average to fall 1.82 percent to close just above critical support at 8,000. According to advanced reports, the US economy contracted in Q4 by the most since Q1 1982 at a rate of 3.8 percent, marking the second consecutive quarter of contraction. This was actually a bit better than forecasts, as a Bloomberg News poll shows that economists had expected a decline of 5.5 percent. All told, US real GDP for 2008 slowed to a 1.3 percent pace of growth, the lowest since 2001. The decline in GDP could be attributed to a variety of factors, including a 3.5 percent drop in personal consumption, a 12.3 percent decline in gross private investment, and a 19.7 percent plunge in exports. We already know that the US has been in recession since December 2007, per the National Bureau of Economic Research (NBER), but one of the bigger questions now is how long the recession will last for. It will be important to watch gauges of employment and business activity for the early months of 2009, as the latest trends suggest that GDP could continue to fall sharply in Q1 and Q2. Also worth keeping in mind that today's GDP report is simply the advanced reading, and with two more revisions due out on February 27 (preliminary) and March 26 (final), these figures could ultimately change dramatically.

The release of personal income and personal spending figures for the month of December is likely to highlight the dismal status of consumption in the US. Income is forecasted to contract for the second consecutive month at a rate of 0.4 percent, and perhaps even worse, spending is anticipated to contract for the sixth straight month at a rate of 0.9 percent. The impact of the reports on the markets may be limited since Q4 GDP has already been announced. Unlike these releases, the ISM Manufacturing index will give a more timely view of conditions in the economy. The index is anticipated to fall to a nearly 29-year low of 32.5 in January from an upwardly revised 32.9. This would mark the twelfth straight month of contraction in business activity, suggesting that the recession could continue through at least the first half of 2009. Weaker than expected results could lead flight-to-safety to push the US dollar higher, while surprisingly strong numbers could weigh the currency down.

Euro Tumbles as Euro-zone CPI Falls to 1999 Low, Adds to Speculation the ECB Will Cut Rates on February 5

The euro remained under heavy pressure on Friday as Euro-zone CPI estimates fell further below the European Central Bank’s 2.0 percent target to a nearly 10-year low of 1.1 percent from 1.6 percent., and when considering that the Euro-zone has experienced steady increases in unemployment, and increasingly pessimistic consumer and business confidence, there is potential that the central bank will cut rates again. However, evidence suggests that the ECB will wait until March 5, and this is exactly what a Bloomberg News poll of economists is forecasting as well. Indeed, after the ECB cut rates to a record low of 2.00 percent on January 15, Mr. Trichet said that the next "important" meeting would be in March when they release new projections for growth and inflation, suggesting they have no plans to adjust interest rates in February. However, he refused to call 2 percent the lower limit for interest rates, leaving the door open to further reductions in coming months. As a result, the 7:45 ET announcement may not garner as much attention as ECB President Jean-Claude Trichet’s 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 signals that they may leave rates unchanged during their next meeting, the currency could actually rally.

British Pound Dominates Against the Majors on Massive Retracement - Can This Continue?

The British pound was the strongest of all the majors not only on Friday, but during the entire week, as the currency trades in a highly speculative manner. Indeed, over the past 5 days, the British pound has rallied 8.6 percent against the New Zealand dollar and roughly 6.3 percent against the euro and Japanese yen in an attempt to recoup the massive losses accumulated between October 2008 and January 2009. However, with both Credit Suisse overnight index swaps and a Bloomberg News poll reflecting expectations that the Bank of England will cut rates by another 50 basis points at 7:00 ET on Thursday to a new record low of 1 percent., it’s worth wondering how far this British pound rally can extend. There are few doubts that the BOE will at least consider slashing rates again since the UK remains in a deep recession and officials anticipate that things will only get worse. In fact, BOE Monetary Policy Committee Member David Blanchflower, who is easily the most outspoken and dovish member on the Committee, issued very dovish comments on January 29, saying that the UK economy may face a recession worse than that of the one in the 1980’s and that the Bank Rate needs to be cut “further and quickly.” Furthermore, he said that the MPC has considered their options in the case that the Bank Rate is cut to zero, which was quite timely comment when you consider that Chancellor of the Exchequer Alistair Darling gave the BOE permission today to buy 50 billion pounds worth of bond and commercial paper in order to alleviate tight credit conditions. Overall, this leaves the odds in favor of year another rate cut by the BOE on February 5, but the reaction of the British pound may depend on what sort of bias is reflected in the Monetary Policy Committee’s subsequent statement.

Australian Dollar Bound to See High Volatility Ahead of RBA Rate Decision

The Australian dollar could face bearish pressures on Monday night, similar to what the New Zealand dollar experienced on January 28, as the Reserve Bank of Australia is anticipated to cut rates in their fifth consecutive meeting at 22:30 ET, with a Bloomberg News poll of economists calling for a 100 basis point cash rate target reduction to a record low of 3.50 percent. However, only a larger-than-expected rate cut or comments suggesting they will continue to reduce rates aggressively may weigh on the Australian dollar. Overall, Australia is facing major headwinds from financial market instability, which has led to tighter credit conditions, as well as from both domestic and foreign demand. Indeed, global slowdown is hurting exports, something the Australian economy depends on for employment and broad growth. The situation has not been helped by significantly lower commodity prices, though it has served to cool inflation pressures, which leaves the RBA additional leeway to make monetary policy more accommodative in coming months.

Terri Belkas is a Currency Strategist at FXCM.