US Dollar, Japanese Yen Tumble as Fed’s Bernanke Stokes Risk Appetite, S&P 500 Gains 4%

US economic news was very disappointing this morning, as the S&P/Case-Shiller home price index tumbled by a record 18.23 percent in Q4 and the Conference Board’s consumer confidence index hit the worst level since record keeping began in 1967. Meanwhile, Federal Reserve Chairman Ben Bernanke’s prepared remarks before the Senate Banking Committee didn’t reflect much in the way of new updates, as he essentially just provided a timeline of the development of the financial crisis. Bernanke reiterated the Federal Open Market Committee’s (FOMC) stance that “economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time,” suggesting that the fed funds target will remain at a record low range of 0.0 percent - 0.25 percent through 2009. He also noted that the financial markets have stabilized somewhat in recent months, but that some stresses still remain, as evidenced by the fact that “most securitization markets remain shut, other than that for conforming mortgages, and some financial institutions remain under pressure.” Bernanke expressed optimism that the initiatives discussed by Treasury Secretary Tim Geithner on February 10 would eventually work to “further stabilize our financial institutions and markets, improving confidence and helping to restore the flow of credit needed to promote economic recovery,” but that there is currently a "painful adjustment" going on toward more saving. Indeed, most businesses thrived off the tendency of consumers to leverage themselves to the hilt with credit card debt in order to obtain a better quality of life. However, with everyone becoming increasingly conservative, that sort of risk appetite may become a thing of the past as individuals spend less and save more, which will hurt the sectors that benefited most from once-robust consumption.

During the Q&A session, Bernanke brushed off the notion of nationalization, but also said that the US lacks a “regime for closing big, critical firms” and that any reforms should include a way to do so. Bernanke also said that "there are some banks that are too big to fail,” but refused to commit to never shutting down a big bank. With the Federal Reserve saying that they want to learn the "true positions" of US banks, it seems like things could get worse before they get significantly better, but based on the surge in equities and forex carry trades on Tuesday, the markets seem to be believing otherwise. If this sentiment intensifies, both the US dollar and Japanese yen may be in for further declines, with the outlook for the former hinging upon a break below Monday’s low. Meanwhile, the yen may be at even greater risk due to its closer link to risk trends.

Looking ahead to Wednesday, Bernanke will testify again, this time in front of the House Financial Services Committee at 10:00 ET. Most of the commentary will likely consist of repeats from today, but biased or unexpected remarks could impact risk trends. At the same time, the National Association of Realtors' (NAR) existing home sales report is expected show that they rose for the second straight month at a rate of 1.3 percent in January to 4.8 million. However, this is still fairly close to the record low of 4.45 million reached in November, which may not even describe the true extent of the weakness in the housing sector as record keeping only goes back to 1999. Nevertheless, another increase would suggest that lower home prices and mortgage rates are helping to provide a small boost to demand for previously-owned homes.

Euro Up Despite Record Declines in Euro-zone Industrial Orders, German Investor Sentiment

The euro rallied throughout much of the US trading session thanks to a rise in risk appetite, and despite the fact European economic data was broadly disappointing. Euro-zone industrial new orders fell for the fifth straight month in December at a rate of 5.2 percent, making the worst string of declines since record keeping began in 1994. The annual rate showed a sharp contraction of 22.3 percent, and while this is up from the record low of -27.4 percent in November, the outlook for European producers looks gloomy as both domestic and foreign demand wane. Meanwhile, the IFO index of German business confidence moved in line with expectations, as there was broadly weak sentiment on the business climate with the index down at a new record low of 82.6, while the index gauging current economic conditions fell to nearly match the 6-year low at 84.3. On the other hand, the outlook for growth improved, with the index up to 80.9 from the December record low of 76.9, amidst prospects for recovery in the long run thanks to intervention efforts by European governments and the European Central Bank’s past rate cuts.

British Pound Slips as BOE’s Sentence Cites Deflation Risks - UK GDP Revisions on Wednesday

The British pound ended Tuesday modestly lower against the greenback, as it was one of the weakest of the major currencies and gained only against the Japanese yen. Comments by Bank of England Monetary Policy Committee member Andrew Sentance certainly did not help the British pound, as he cited an increased risk of deflation if “the recession is prolonged and deep, and though “persistent” price declines “remain an outside risk,” there is “a strong case for providing additional stimulus to the economy to head it off more decisively.” Sentence’s remarks added to speculation that the BOE will move to buy gilts in order to increase the money supply and bring down broad interest rates. Looking ahead to Wednesday, the preliminary reading of Q4 GDP for the UK is forecasted to revised even lower, down to -1.6 percent from -1.5 percent, which would still mark the lowest level since Q2 1980. The UK has been hit particularly hard by the credit crunch, especially since the country became one of the biggest financial centers in the world. This has translated into a full-on collapse of the housing market, climbing job losses, and weak consumption. Furthermore, with growth slowing around the world, demand for British exports has declined as well, putting a large burden on manufacturers. Overall, a greater-than-expected decline could lead the British pound lower as the data would raise the odds the Bank of England will cut rates again on March 5. On the other hand, if GDP is a bit better than forecasts, the currency could gain.

Terri Belkas is a Currency Strategist at FXCM.