US Dollar, Japanese Yen Gain on Concerns About Financial Stability, Signs of Deepening Recession

The US dollar and Japanese yen were some of the strongest of the major currencies as lingering risk aversion led Asian, European, and US stock markets lower. Indeed, financial market news was dismal around the globe, as Japan’s Hitachi and Nippon Paper Group slashed earnings targets, Moody’s downgraded Barclays debt rating on potential credit writedowns, while US industrial shares plunged as manufacturing reports reflected a deepening recession in the sector. Indeed, while the Institute for Supply Management’s (ISM) manufacturing index rose slightly to 35.6 in January from 32.9, the index has remained below 50 since February 2008, signaling a contraction in business activity. A breakdown of the report shows that the employment component held at a more than 26-year low of 29.9, boding ill for Friday’s US non-farm payrolls, while the production and new order components remain just above the record lows reached in December.

Meanwhile, US personal spending fell a greater-than-expected 1 percent during the month of December, marking the sixth straight month of declines. At the same time, personal income slipped 0.2 percent to cap off the longest stretch of declines since November 1953 - January 1954. It is already clear that consumption growth took a heavy hit in the second half of 2008, as a 3.5 percent drop in personal consumption helped drag Q4 GDP down to a nearly 27-year low of 3.8 percent. However, in light of the sharper-than-anticipated slump in December spending, there is increased potential for downward revisions to GDP upon on February 27 (preliminary) and March 26 (final).

Looking ahead to Tuesday, the National Association of Realtors' (NAR) pending home sales report is forecasted to show that contract signings for the purchase of previously owned homes stagnated in December following three straight months of contraction and a 9.6 percent drop in November from a year earlier. Indeed, last week NAR reported that existing home sales actually jumped 6.5 percent in December to 4.74 million from 4.45 million as median prices tumbled 15.3 percent from a year earlier to $175,400, though new home sales continue to fall to record lows. As a result, there is potential for a better than expected result on Tuesday morning, which could help to boost investor sentiment and thus, currency pairs like USD/JPY.

Australian Dollar Under Pressure Ahead of RBA Rate Decision

Despite a rally during the first half of the US trading session, the Australian dollar remains under pressure and could see further declines toward 0.6075 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. This would be similar to what the New Zealand dollar experienced on January 28, but 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.

Euro Bounces from Technical Support Versus US Dollar, British Pound

The euro was one of the only currencies to gain against the US dollar on Monday, but only after EUR/USD bounced from rising trendline support at 1.2705 while EUR/GBP recovered from Fibonacci support near 0.8800. There was little in the way of news released from the Euro-zone, but looking ahead to Tuesday morning’s reports, producer prices in the Euro-zone are forecasted to have fallen for the fourth straight month at a rate of 1.2 percent during December, while the annual rate could slow to 2.1 percent. We've already seen Eurostat's estimates for January CPI plunge to a nearly 10-year low of 1.1 percent, and if this upcoming release of input costs fall more than anticipated, the markets may shift to price in a rate cut by the European Central Bank on Thursday and thus lead the euro lower. As it stands, Credit Suisse overnight index swaps are pricing in a 77 percent chance of a 25bp cut, but based on comments by ECB President Jean-Claude Trichet following their last meeting, a Bloomberg News poll shows that economists expect that the ECB will hold off until March before considering reducing rate again.

British Pound Pummeled by Moody’s Downgrade of Barclays’ Debt

The British pound is easily one of the most volatile currencies in the market right now, as it tumbled against the US dollar, euro, and Japanese yen amidst heightened financial market concerns. This trigger this time around was news that Moody’s lowered Barclays’ debt rating, saying that it expected “significant further losses” on credit-related writedowns. As one of the UK’s largest banks, this has spurred already strong fears that the worst is not over yet for the UK financial sector. Furthermore, the news adds to speculation that the Bank of England will indeed cut rates again on Thursday, especially since both Credit Suisse overnight index swaps and a Bloomberg News poll reflect expectations that they will reduce the Bank Rate to a new record low of 1 percent. This is within the realm of possibilities since the UK has tipped into recession and the BOE, and UK government, anticipate that things will only get worse. In fact, Bank of England 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.”

Terri Belkas is a Currency Strategist at FXCM.