US Dollar: Outlook is Grim but a Recovery Could Be Swift
The news that Bank of America will be plowing $2 billion into Countrywide Financial Corp was supposed to be very bullish for the financial markets, but the move in the Dow today was far from impressive. Carry trades and high yielding currencies are only higher because of gains in the Asian and early European trading sessions. The Nikkei closed up 400 points after the Bank of Japan left interest rates unchanged. Credit and housing concerns continue to grapple the market as traders and investors alike question whether the worst is truly behind us. Although everyone may be breathing a little easier with no new blowups announced, the drop in bond yields suggest that many buyers still prefer to park their money in Treasuries or cash. Jobless claims were slightly higher than expected last week, but not as bad as they could be given the recent layoff reports. According to the Wall Street Journal, in the past 10 days alone, mortgage companies have shed 13k jobs. In all likelihood, many of those people have yet to file for unemployment benefits. Non-farm payrolls for the next few months should be particularly horrid. Meanwhile, new home sales and durable goods for the month of July are due for release tomorrow. Home sales are expected to drop for the third straight month. The market is only looking for a modest 1.7 percent drop, but sales could easily be a lot worse. If they are not, that would only mean that the August and September numbers would bear the brunt of weak demand. Last month, home builder confidence dropped to a 16 year low while housing starts dropped to a 10 year low. Builders and home owners are both feeling the crunch. RealtyTrac announced earlier this week that foreclosures in the January-July 2007 period jumped 60 percent compared to last year. Senate Banking Committee Chairman Christopher Dodd also added that the rate of foreclosures is at a 37 year high. The outlook for the US economy is grim, but the eventual recovery could come quickly. The strong demand for Treasuries indicates that companies and global investors are still awash with cash. They only want to hoard that cash for the time being until the storm passes and once it does, buyers may come back in force.

Euro Rallies as ECB Sticks to Plan for Raising Interest Rates
Despite the turmoil in the financial markets, the European Central Bank still wants to push forward with raising interest rates next month. After injecting EUR$40 billion Euros into the financial system, they put out a press release saying that they still hold the same monetary policy stance as the one expressed by ECB President Trichet on August 2, 2007. On that day, he had told the markets that they needed to exercise strong vigilance, which was their way of saying “expect an interest rate hike next month.” Last night’s reminder sent a strong message to the markets about the ECB’s plans to continue raising interest rates. As a result, rate hike expectations have soared from 5 percent up to 50 percent. This renewed possibility of an interest rate hike has helped the Euro rally against both the US dollar and Japanese Yen. As long as there is no new blowup driving another wave of flight to safety, the expectations of three interest rate cuts from the Federal Reserve before the end of the year against the possibility of a rate hike from the ECB should keep the EUR/USD above 1.3450. Meanwhile Swiss economic data was mixed. Second quarter employment was stronger but the ZEW survey of analyst sentiment deteriorated. The Swiss franc has slipped, but that is partly due to the rebound in carry.

Bank of Japan Leaves Rates Unchanged, But Plan on Normalizing Rates in Months to Come
The Japanese Yen crosses are all up strongly today following the Bank of Japan’s decision to leave interest rates unchanged. Comments from Governor Fukui suggest that the only thing holding the central bank back from raising rates is the problems in the global financial markets. They still feel that it is wrong to keep interest rates at such low levels. In the words of Fukui, “distortions and the misallocation of resources could occur if interest rates are kept at levels inconsistent with the economy. They are not ruling out the continual normalization of interest rates even if the liquidity remains a problem globally. The market’s appetite for risk will continue to drive the movement in the Yen crosses. The sharp rally in the Nikkei overnight played a big role in driving pairs like USD/JPY, GBP/JPY and AUD/JPY higher. If the Nikkei continues to rise tonight, then we can expect USD/JPY to take another stab at 117.00.

Canadian, Australian and New Zealand Dollars Continue to Rebound
The Australian, New Zealand and Canadian dollars were the best performing currencies against the Japanese Yen and US dollars today. Although they still have a long ways to go before recapturing all of the past week’s losses, today’s breakout points to the potential for further gains. Whether or not these currencies will continue to rise will be dependent upon the sustainability of the demand for yield. As long as no more bad news hits the wires demand could remain steady, but keep an eye out for tomorrow’s US new home sales report. In the meantime, there is no Canadian or Australian data due tomorrow, but New Zealand will be reporting trade balance numbers this evening. The kiwi ended last month only slightly below where it started which means that trade should still be restrained by the high level of the currency. August however is looking very promising for exports since the currency has dropped as much as 18 percent.

British Pound Breakouts Out of Weeklong Trading Range
The British pound broke out of its weeklong trading range thanks to broad based demand for high yielding currencies and stronger economic data. Adding to the list of positive reports from the UK this wee, was second quarter business investment which rose 0.8 percent on a quarterly basis and 7.4 percent on an annualized basis. The second release of Q2 GDP is due out tomorrow.

Kathy Lien is the Chief Currency Strategist at FXCM.