US Dollar, Japanese Yen Falter as Increased Confidence Propels S&P 2.38% Higher

The US dollar and Japanese yen both tumbled on Wednesday, as improved risk appetite benefited riskier assets like the commodity dollars and stocks, with the DJIA and S&P 500 both ended the day up over 2 percent. Much of this was attributed to news that China is expected to announce a second stimulus package during Friday’s opening of the National People’s Congress, suggesting that Chinese demand may hold up enough to support other global economies. Meanwhile, the forex markets showed little response to news that conditions in the US non-manufacturing sector - which accounts for approximately 70 percent of total economic activity in the country and includes retail, services, and finance - worsened in February as the Institute for Supply Management (ISM) index fell to 41.6 from 42.9, which is just above the record low of 37.4 reached in November. A breakdown of the index shows that overall activity, new orders, and employment all remained well below 50, signaling a further contraction. While we already know that the US economy fell into recession in December 2007, this data helps to gauge how long the recession will drag on for, and based on this data, the forecast looks just as bleak as what the Federal Reserve observed in their monthly Beige Book report.

Ten of the twelve Fed districts reported "weaker conditions or declines in economic activity," and the sole exceptions were the Philadelphia and Chicago Fed districts, which reported that their respective economies "remained weak." Going forward, the districts said that the outlook for "near-term improvement in economic conditions" was "poor," as growth is not anticipated to recover before late 2009 or early 2010. Furthermore, the Beige Book said that unemployment has risen in all areas due to "rising layoffs and hiring freezes," which has contributed to a reduction or elimination in "upward wage pressures." The report went on to say that multiple "reports pointed to outright reductions in hourly compensation costs, through wage reductions and reduction or elimination of some employment benefits." Clearly, this leaves potential open for yet another sharp increase in the US unemployment rate on Friday and suggests that consumption will continue to be lackluster.

Overnight, Japanese capital spending (excluding software) is projected to fall for the seventh straight quarter in Q4, as the annual rate may plunge by the most in more than seven years at a rate of 15.3 percent. Businesses, which depended heavily upon robust foreign demand, have had to come to terms with the impact of the appreciation of the Japanese yen and the global economic slowdown/recession, as the latest figures from January show that exports fell 45.7 percent from a year earlier. With the Japanese government and economists all of the world forecasting that global growth will time quite some time to recover, businesses have no reason to invest in their operations and if anything, they are looking to cut away any and all excess fat. Overall, readings in line with expectations will signal what many already anticipate: that the Japanese recession will only deepen during the first half of 2009. The news has potential to impact investor sentiment during the Asian trading session, leading the Nikkei lower and thus, the Japanese yen higher on risk aversion.

British Pound, Euro Outlooks Hinge Upon Thursday’s ECB, BOE Rate Decisions

Bank of England - The already-volatile British pound is bound to face additional volatility this week as a Bloomberg News poll reflects 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 0.50 percent. This is indeed within the realm of possibilities given the exceptionally dovish commentary we’ve been hearing from BOE officials lately. On Tuesday, BOE Monetary Policy Committee (MPC) member Andrew Sentance 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.” On Wednesday, BOE MPC member David Blanchflower, said that the UK recession may worsen "significantly" and that the downturn has not yet hit a "bottom," which left UK monetary policy "overly restrictive" with the Bank Rate at a record low of 1 percent. He went on to say that the central bank should cut rates to at least 0.50 percent, go neutral and then pursue quantitative easing "quickly," something that the UK Treasury has yet to approve. It is worth noting that Blanchflower is easily the most dovish member of the MPC, but his remarks obviously still hold some weight in the markets. Overall, this leaves the odds in favor of another rate cut by the BOE on March 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. If the BOE suggests they will leave rates at 0.50 percent for the foreseeable future, the British pound could actually gain. On the other hand, indications that the central bank is open to reducing rates further, or that quantitative easing may be approved by the UK Treasury could weigh on the currency.

European Central Bank - The decline in Euro-zone CPI estimates well below the European Central Bank’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 on March 5 by 50 basis points to 1.50 percent. Indeed, after the ECB cut rates to a record low of 2.00 percent on January 15, ECB President Jean-Claude Trichet said that the next "important" meeting would be in March when they release new projections for growth and inflation. Furthermore, 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 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. On the other hand, if the ECB signals that they may leave rates unchanged during their next meeting, the currency could actually rally.

Terri Belkas is a Currency Strategist at FXCM.