US Dollar, Japanese Yen Up as Financial Concerns Spark Sell-Offs in Risky Assets Around the World

The US dollar and Japanese yen maintained their strength against the majors, with the exception of the British pound, as Moody’s ratings agency warned that the eastern European banking system was increasingly vulnerable to a “steep and long economic downturn,” and that western European banks with locations in eastern Europe may face ratings downgrades. The decline in risky assets, like equities, was not helped by President Obama’s signing of the $787 billion stimulus package at the end of the day, as details for the reformed version of the Troubled Asset Relief Program (TARP) have yet to be revealed. In US economic news, the New York Fed’s “Empire” index plummeted to a new record low of -34.65 in February from -22.2, adding to indications that the manufacturing sector is suffering at the hands of weakening demand both domestically and abroad. The breakdown of the report followed similar trends to what we’ve seen over the past 6 months: declining prices, persistent contractions in new orders, and signs of additional layoffs. Meanwhile, net long-term TIC flows for the month of December rose a greater than expected $34.8 billion, up from -$25.6 billion in November, as foreign investors increased purchases of equities, notes, and bonds. A closer look also shows that net foreign purchases of Treasury notes and bonds were $14.9 billion, compared with sales of $25.8 billion a month earlier, while net Treasury bill purchases were at $25.3 billion in December, down from $82.1 billion in November. Despite dismal US trade and fiscal deficits, demand for “safe haven” Treasuries are far from falling off a cliff. However, as we’ve been discussing in the DailyFX Forums, there are long-run risks for the US dollar if foreign demand ultimately takes a hit.

Looking ahead to Wednesday, the concurrent releases of the US import price index, housing starts, and building permits at 8:30 ET could stoke volatility in the forex markets. First, import prices are forecasted to have fallen for the sixth straight month at a rate of -1.3 percent, while the annual rate may hit a fresh record low of -11.2 percent, as the stronger US dollar as well as lower commodity prices contributes to sharp declines in the price of foreign goods shipped to the US. Meanwhile, US housing starts and building permits are forecasted to have dropped to new record lows in January of 530K and 525K, respectively. While much of this news has already been priced into the markets, the combination of signs of deflation and indications that the end of the housing collapse isn’t in sight could weigh on risk appetite during the start of the US trading session.

Finally, the 14:00 ET release of the minutes from the January Federal Open Market Committee (FOMC) meeting, when they left the fed funds target range at 0.0 percent - 0.25 percent, are likely add to indications that they will leave the target unchanged throughout much of 2009. In fact, the FOMC said in their post-meeting statement that their focus had shifted to “support the functioning of financial markets and stimulate the economy through open market operations and other measures that are likely to keep the size of the Federal Reserve's balance sheet at a high level.” The minutes may have an impact on risk trends if the Committee’s outlook proves to be more bearish than currently perceived. However, if the news happens to be positive for the stock markets, it may also be negative for the greenback, which has been trading solely as a safe-haven asset lately.

British Pound Holds Up as UK CPI Remains Well Above 2% Target, BOE Minutes Could Impact Trade on Wednesday

The British pound was actually one of the stronger currencies in the forex markets on Tuesday, slipping only against the greenback, as the latest inflation data suggests that the Bank of England may be hesitant to slash rates to zero in the near-term. Though UK CPI fell 0.7 percent in January, the annualized pace remained well above the BOE’s 2 percent target at 3.0 percent, down from 3.1 percent in December. The BOE has indicated that they expect inflation to fall much further this year, but the direction of interest rate expectations for the UK may hinge upon the release of the BOE’s meeting minutes on Wednesday at 4:30 ET. During the February meeting, the BOE’s Monetary Policy Committee (MPC) slashed the Bank Rate by 50 basis points to yet another record low of 1.00 percent, as expected. However, the British pound subsequently rallied as the MPC suggested that they may not cut rates again on March 5. Since then, though, BOE Governor Mervyn King’s comments have signaled otherwise and if the MPC’s comments and outlooks signal that the central bank will reduce the Bank Rate further, the British pound could pull back.

Euro Under Pressure Amidst Eastern European Banking Risks, Signs of Distress

The EUR/USD pair broke below key support at 1.2700 on Tuesday morning, suggesting the pair could target the 2008 lows of 1.2329 as signs of distress in the Euro-zone continue to emerge. First, Moody’s rating agency warned that the eastern European banking system was increasingly vulnerable to a “steep and long economic downturn,” and that western European banks with locations in eastern Europe may face ratings downgrades. According to a report in the Financial Times, “Euro-zone banks have the largest exposure to central and eastern Europe, with liabilities of $1,500 billion,” which works out to be “about 90 percent of total foreign bank exposure to the region.” Next, German Finance Minister Peer Steinbrueck said on Monday evening that European countries may have financially assist EU member nations, but with no firm structure in place, it may prove to be an arduous task to construct a feasible bailout plan. Indeed, there are concerns that European banks have yet to announce massive writedowns, which leaves systemic risks lingering for the world’s financial markets. Until everything is out in the open and toxic assets are removed from the books for financial institutions, risk aversion is likely to remain a persistent issue.

Terri Belkas is a Currency Strategist at FXCM.