US Dollar: Nervous Market Leads to Nervous Price Action
The price action in the financial markets indicates that traders are nervous. Last Friday’s non-farm payrolls number was horrid, paving the way for a minimum of 25 basis points of easing on September 18. At this time, the market has even priced in a greater than 50 percent chance of a half point cut and the probability that the Fed will lower interest rates by 75bp is now greater than the probability that they will leave rates unchanged. Yet, Fed officials continued to do what they know best, which is attempt to pacify the market’s fears. Atlanta Fed President Lockhart indicated that even though the labor market is weakening, consumer spending remains strong while Dallas Fed Fisher said the US economy is weathering the storm thus far. Surprisingly, there is still a minority that believes the Fed will not cut interest rates, which may be part of the reason why the stock market and carry trades have been so volatile today. An article by Reuters is arguing that the Fed may forgo cutting the Fed Funds rate completely and cut the discount rate instead. We think that this is unlikely, but at the same time, this could also be the driver behind today’s wild swings in the Dow. The index was down as much as 75 points intraday before reversing up 75 points and then giving back those gains to end positive by only 14 points. Although the central bank is still optimistic, many other agencies are not. The National Association of Business Economics and the Blue Chip Economic Indicators newsletter are both seeing an increased chance of a recession. These people help companies plan their spending in the months to come which is extremely important for the economic outlook. Although the trade balance will be released tomorrow, the big US release this week is retail sales on Friday. As long as there are no blowouts in the trade number, we could see a bit more recovery in the US dollar before Friday. The overall trend, however, is still bearish and we do not expect last Friday’s losses to be recovered. Bernanke is scheduled to speak tomorrow but don’t expect any particularly market-moving comments from the Fed Chairman. His topic is Global Imbalances: Recent Developments and Prospects. He will be reading from prepared text and there will be no question and answer session.

Euro: Still Aiming for its All-Time Highs
Stronger French economic data and growing concerns about the US economy are helping the Euro rally for the fourth trading day in a row. The currency pair is now within 50 pips of its all-time high and barring any unforeseen circumstances, that level is too close for traders not to test. French industrial production jumped 1.3 percent in the month of July, signaling a recovery in GDP growth in the third quarter. In an environment where the outlook for US growth is worsening, the upside surprise to European data is shining a bright light on the ECB’s still hawkish monetary policy. We do not believe the ECB will raise rates again this year, but they still left the door open for that possibility which at bare minimum tells us that they are not considering lowering interest rates. A number of ECB officials will be speaking tomorrow including Trichet. The ECB has not decided on what they will be doing with interest rates over the next few months and we expect the comments tomorrow to reflect that.

Is the New Zealand Dollar Bottoming?
The New Zealand dollar is the best performing currency in the foreign exchange market today. Against the US dollar, the kiwi is up 0.8 percent and against the Japanese Yen it is up 1.15 percent. With retail sales and the Reserve Bank of New Zealand rate decision this week, the currency pair is in play. After the past 2 week’s sharp losses, the faster than expected producer price growth in the second quarter came as a welcome surprise. It has also helped the currency outperform the Australian dollar, which was weighed down today by softer than expected home loans data. Technically, the New Zealand dollar looks poised for more gains, as long as there isn’t another massive wave of carry trade liquidation over the next few days.

British Pound Hit by Weak Producer Prices
The British pound sold off against both the Euro and US dollar after much weaker than expected producer prices in the month of August. Input PPI dipped by 0.5 percent while output PPI increased by a tepid 0.1 percent on a monthly basis. As a key inflation indicator, the drop in producer prices will satisfy doves who believe that the Bank of England will remain on hold until the remainder of the year. The UK housing market on the other hand is holding steady. House prices according to the DCLG increased to 12.4 percent year over year in July which helped to offset news that UK subprime specialist Victoria Mortgages is no longer funding new loans. The trade balance and leading indicators are due for release tomorrow. The strength of the British pound in July suggests that both numbers could worsen.

Weak GDP Takes a Bite Out of the Japanese Yen
The Japanese Yen weakened against every major currency today with the exception of the Australian dollar. GDP growth in the second quarter was revised down to 1.2 percent from a preliminary estimate of positive 0.5 percent. Although consumer spending rose 0.3 percent, business investment fell 1.2 percent. The sharp surprise is a major setback for the Bank of Japan, which has been looking for an opportunity to raise interest rates. This is especially true since money supply and the Eco Watchers index both deteriorated as well. Weak GDP in the context of weakening global growth should keep the central bank on hold for the remainder of the year.

Kathy Lien is the Chief Currency Strategist at FXCM.