US Dollar: Will the Fed be Proactive or Reactive?
Volatility has rocked the financial markets after the shockingly weak non-farm payrolls report. Economists were looking for companies to add 100k jobs last month, but they ended up firing more people than they hired. The Federal Reserve can no longer pretend that the subprime and credit crisis is not having an impact on the overall economy. It is, and in a very serious way. At the end of trading today, Countrywide Financial announced job cuts of up to 12k. The only choice that they have at this point is between cutting interest rates by 25 or by 50bp. After today’s non-farm payrolls number, the interest rate curve is pricing in 75bp of easing. There are even rumors about the possibility of an emergency intermeeting cut. The chance of this is low since the FOMC meeting is only 7 trading days away. The bigger question will be whether the Fed chooses to be proactive or reactive. If they really want to do more than put a band aid on the problems that the US economy currently faces, they will need to surprise the markets with a half point cut, but based upon the measures that we have seen from Bernanke so far, it is more likely that the Fed will play it safe by cutting interest rates 25bp. The weak non-farm payrolls number has sent stocks, carry trades and the Dow tumbling. The dollar has been completely stripped of its safe haven status as job losses point to weak spending in the months to come as well as the risk for a recession. Retail sales are the most important release on the economic calendar next week. After today’s payrolls number, everyone will be looking for consumer spending to confirm that the economy is continuing on a downward spiral but we actually don’t think that retail sales in August will be that bad. The last time job growth was negative was in August 2003. That month retail sales jumped 1.6 percent, but in September and October, spending fell -.8 percent and -.5 percent respectively. Therefore, it may be another month before we see a meaningful contraction in spending.

Carry Trades: Expect More Losses
None of the Japanese Yen crosses have been spared from today’s massive and widespread exodus out of carry trades. With the exception of CHF/JPY, every other yen cross lost a minimum of 200 pips. Risk aversion is back and we expect it to be here to stay. Unless the Fed steps in with an intermeeting rate cut, the Dow will want to test the 13,000 level by the end of next week. As currencies and equities continue to move together, this should have a negative impact on the Yen crosses as well. When Asian traders return to the markets on Sunday night, we expect them to react the same way as US and European traders. Further losses in the Dow will also make it a difficult night for carry trades. Risk or no risk is still the big driver of the markets and based upon today’s movements, it seems that no one wants to take on any risk. Japan will be releasing second quarter GDP along with industrial production CGPI, current account and consumer confidence next week. These reports will probably matter little to the overall market as they focus on figuring out how much worse the US economy can get.

Euro Breaks Out, Headed Towards All-Time Highs
The Euro has finally broken out on the back of sharply weaker US economic data. Next week, we fully expect the EUR/USD to make a run towards its all time high of 1.3850, which is less than 100 pips away. With the ECB likely to keep interest rates on hold for the remainder of the year, the EUR/USD will once again become the anti-dollar. This means that weak US data will drive the EUR/USD higher while strong US data will drive the currency pair lower. This has not been the case over the past few weeks because weak US data would lead to a flight to safety into US dollars and US treasuries. We have yet to see a material slowdown in Eurozone economic data and even though the central bank will probably not be able to raise interest rates again this year because of problems in the US, they still remain hawkish which is a sharp contrast to the Federal Reserve’s expected monetary policy bias. A number of ECB officials are scheduled to speak next week including Trichet. Even though there is a lot of economic data on the calendar, with the exception of Eurozone CPI, nearly all of these releases are Tier 2, or non-market moving.

Bank of England Leaves Rates Unchanged and Releases Surprising Statement
The British pound is strong and will probably be a lot stronger in coming days thanks to the sharp contrast between economic growth in the US and in the UK. Throughout the past 2 weeks, we have seen UK data surprise to the upside. In the US however, there could be no bigger disappointment than the one we have seen today. As much as the UK will fall victim to a slowdown in the US, given the country’s current stability, the impact should be limited. In the week ahead, expect the British pound to be in play. House prices, PPI, the trade balance and employment data are due for release. These are potentially market moving numbers.

Australian, New Zealand and Canadian Dollars Hit by Carry Trade Liquidation
The Australian, New Zealand and Canadian dollars all fell under the weight of liquidation. Even the Australian dollar, which has been supported by strong economic data gave back some of its prior day’s gains. There is no Australian data next week, but the RBNZ will be meeting to decide on interest rates so expect decent volatility in the New Zealand dollar. PPI and retail sales are also due for releases. Over in Canada, housing starts, trade balance and manufacturing data are due out. Unlike the US, Canada reported stronger than expected employment numbers today; 23k jobs were added in the month of August, which compares to the 11k rise in July.

Kathy Lien is the Chief Currency Strategist at FXCM.