U.S. equities turned positive, erasing triple digit losses in the second half of the NY trading session. The improvement in risk appetite also extended to currencies as safe haven flows eased out of the U.S. dollar. The British pound, Swiss Franc and commodity currencies benefited from the weakness in the greenback. The Japanese Yen moved lower which is natural when risk has improved but the sell-off in the euro reflects the difficulty of finding buyers ahead of the EU Stress Test results and particularly after most short euro positions have been shaken out of the markets. No U.S. or European economic is scheduled for release tomorrow which leaves the market’s focus on Bernanke’s testimony on the monetary policy and the economy. Although the Fed Chairman will face extensive grilling by the members of the Senate Banking Panel, currency traders only want Bernanke to answer 3 questions:

3 Questions for Bernanke

1. Has the U.S. economy improved or deteriorated over the past few months?
2. Is the outlook for growth balanced, skewed to the downside or upside?
3. What is Plan Z?

Has the U.S. economy improved or deteriorated over the past few months?

Twice a year Bernanke heads to Capitol Hill to deliver a testimony on the nation’s monetary policy to the Senate Banking and the House Financial Service Committees. The last time he delivered what was once known as the Humphrey Hawkins testimony was in February. Back then he was relatively downbeat about the economy even though he acknowledged that rates will have to be raised at some point (which he will probably mention again). The Fed’s biggest concern was the labor market and how growth will slow once the stimulus starts to fade. Fast forward to July and his prognosis seems to have come true with the housing market feeling the pain of stimulus programs expiring and the labor market relying too heavily on government programs. The latest numbers showed that Non-farm payrolls returned to net job losses last month while consumer spending fell for the second month in row. Manufacturing and service sector activity also slowed while inflationary pressures have been nonexistent. Bernanke will have no choice but to acknowledge the deterioration and could even hint that deflationary risks have grown.

Is the outlook for growth balanced, skewed to the downside or upside?

We expect Bernanke to maintain a subdued tone that should weigh on risk appetite, particularly if he admits that the economic outlook is now skewed to the downside. Back in June, more than half of the FOMC members downgraded their economic outlook dashing any hope of a rate hike before 2011. The Fed also lowered their growth and inflation forecasts, while mentioning deflation for the first time this year. In the past month, the economy has worsened, which should have elevated Bernanke’s concern.

What is Plan Z?

In response to his pessimistic outlook, members of Congress will most likely ask the Fed Chairman for contingency plans. If he could Bernanke would probably opt to lower interest rates to negative levels, but that is not an option. Deferring asset sales is a given and Plan Z could include options such as encouraging banks to lend by bringing the interest paid on bank reserves to zero, reinvest capital repayments from mortgage backed securities, resume purchases of long term Treasuries or mortgage related assets, target a specific level in Treasury yield to combat deflation and linking the pledge to keep interest rates low for an extended period of time to a specific condition. None of these will immediate actions that Bernanke plans to take, but they are probably all in consideration.

Usually this testimony is used by members of the Senate to express their own views and appease their constituency by appearing concerned about the economy. This will be especially true ahead of the mid-term elections in November. According to Macroeconomic Advisers, only 14 percent of the questions Bernanke was asked in the Senate in February were actually about monetary policy. A little more than 25 percent of the questions were about fiscal policy, over which Bernanke has no official responsibility. Other popular topics were the economic outlook (16 percent) and financial regulation (14 percent). A grab bag of other questions included derivatives, income inequality and China’s currency policy.

Kathy Lien is Director of Currency Research at GFT, and runs KathyLien.com.