US Dollar, Japanese Yen Hold Strong as AIG Losses, Bailout Add to Financial Market Concerns

The US dollar and Japanese yen gained as global stock markets fell sharply on news that European Union leaders voted down a request from Hungary for 180 billion euros in aid for the banking systems of Central and Eastern Europe. Risk appetite was damaged further when AIG reported a fourth quarter loss of $61.7 billion, which encouraged the US government to offer a package of equity, new credit and lower interest rates on existing loans in order to prop up the company as they provide systemic risk for the markets.

In economic news, personal income unexpectedly rose 0.4 percent in January following a 0.2 percent decline in December, but this was not because of improved wage growth. Instead, the increase was due primarily to a 3.5 percent boost to "transfer payments", which includes retirement, disability, and unemployment insurance benefits. Meanwhile, personal spending surprisingly jumped 0.6 percent during the same period, though part of this was the result of an increase in prices from the month prior, as retailers implemented heavy discounts during the holiday shopping season. Overall, with credit conditions remaining tight and unemployment surging, the increase in spending doesn't necessarily reflect a recovery in consumer trends. The release of ISM manufacturing also showed an unforeseen rise to 35.8 in February from 35.6, but ultimately, a closer look at the report indicates broadly weak prospects for the sector. Indeed, despite the increase, this was the thirteenth straight month that the index held below 50, which signals a contraction in business activity. Furthermore, the individual components of the index showed that prices paid remain historically low at 29.0, new orders slipped to 33.1, and employment tumbled to 26.1, the lowest since record-keeping began in 1948.

Looking ahead to Tuesday, the National Association of Realtors (NAR) is expected to announce that pending home sales fell 3.5 percent in January following a 6.3 percent increase in December. This would be in line with other measures of performance in the US housing sector for the start of 2009, as the NAR's existing home sales and the Commerce Department's new home sales figures have all indicated that demand is still falling. While this isn't typically a very market-moving report, results that deviate far from expectations have the potential to shake up risk trends for at least a short time.

Euro Consolidates Above 1.2550 as EU Says ‘No’ to Bailout for Eastern Europe

The euro fell sharply as soon as the markets opened on Sunday, and subsequently consolidated above 1.2550 for much of the European and US trading session. The release of Euro-zone CPI, which was stronger than expected at 1.2 percent in January didn’t have a major impact on EUR/USD as risk trends were the real drivers of price action in the forex markets. As mentioned above, European Union leaders voted down a request from Hungary for 180 billion euros in aid for the banking systems of Central and Eastern Europe, triggering some risk averse selling in the stock markets. However, the EU did leave the door open to aid efforts on a country-by-country basis, suggesting that help may eventually be on the way for the nations. For much of the rest of the week, speculation over the end-result of the European Central Bank’s meeting on Thursday could impact the euro, and on a longer-term basis, resistance looms at 1.3000 while support rests at 1.2500. The decline in Euro-zone CPI estimates well below the ECB’s 2.0 percent target, steady increases in unemployment, and increasingly pessimistic consumer and business confidence all suggest that the central bank will cut rates by 50 basis points to 1.50 percent. As a result, the 7:45 ET announcement will garner quite a bit of attention, but traders should also look to Trichet’s post-meeting press conference at 8:30 ET. 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.

British Pound Breaks Below Support - 1.35 Next?

The British pound took a beating on Sunday and Monday as investor confidence remains low and as UK data remained broadly disappointing. First, the Purchasing Managers’ Index (PMI) for the UK’s manufacturing sector slipped down to 34.7 from 35.8, putting it just above the record low of 34.5 reached in November. More importantly, manufacturing PMI has now held below 50 for tenth straight month, signaling a lingering contraction in business activity and suggesting that the UK recession has only deepened in Q1 2009. Meanwhile, UK mortgage approvals held steady at 31,000 in January, but this is still just above the record low of 27,000 reached in November and doesn’t necessarily indicate any stabilization in the collapse of the UK’s housing sector. From a technical perspective, GBP/USD broke below intraday trendline support at 1.4135 today, which may leave the door open for a decline toward the January lows near 1.3500.

Canadian Dollar Down as GDP Falls Most Since 1991, Australian Dollar at Risk Ahead of RBA Rate Decision

The Canadian dollar continues to fall against the greenback, with USD/CAD showing potential to test 1.3000 in the near term, as Canadian GDP fell an annualized 3.4 percent during Q4, the worst drop since 1991. Indeed, sharp declines in oil prices have take a toll on the export and commodity-dependent economy, and the results add to evidence that the Bank of Canada will cut rates on Tuesday morning. Meanwhile, the Australian dollar is trading at a critical point, as AUD/USD is aggressively testing a trendline that has served as support since October 2008. With the Reserve Bank of Australia (RBA) due to announce their rate decision tonight, a break in AUD/USD could occur in the near-term. The RBA is anticipated to cut rates in their sixth consecutive meeting at 22:30 ET on Monday, with a Bloomberg News poll of economists calling for a 25 basis point cash rate target reduction to a record low of 3.00 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, with signs of neutrality likely to actually boost the currency.

Terri Belkas is a Currency Strategist at FXCM.