US Dollar Remains Near Record Lows as Retail Sales Increase Chances of Fed Cut on Tuesday
The US dollar ended Friday very little changed from Thursday, with the currency rallying in the morning as traders shrugged off the less-than-impressive retail sales figures, only to give up those gains in the afternoon. On the surface, the headline advance retail sales report didn’t look so bad; sales rose 0.3 percent in August while the July reading was revised up to 0.5 percent. As usual, however, the devil is in the details. Excluding motor vehicles and parts, sales actually fell 0.4 percent, as clothing purchases eased back despite massive discounting for back-to-school shoppers while sales of building materials dropped off as the housing recession worsens. Meanwhile, service station receipts took the biggest blow of all, with sales down 2.4 percent as gasoline prices fell. Overall, while the report looks relatively healthy upon first glance, the data actually highlights emerging softness in consumption growth that will likely take a toll on Q3 GDP, and this is one of the main factors that will drive the Federal Reserve to cut rates next Tuesday. After all, fixed income, forex, and equity markets are expecting at least a 25 basis point cut, if not 50 basis points, and this speculation likely supported the University of Michigan consumer confidence index, which rose to 83.8 in September from 83.5 the month prior, as consumers were slightly more optimistic regarding the economic outlook. At the time of writing, out of 128 economists polled by Bloomberg, 98 said that they thought the Fed would cut rates by 25 basis points, while 24 said they would go for a sharper 50 basis point cut, leaving only 6 economists anticipating that the central bank will leave rates unchanged. A look at our own poll in the DailyFX Forums shows that traders are more evenly divided, with 46.34 percent indicating that they believe the Fed will cut, while 39.57 percent said that the central bank will take more time to make a decision. The pressure is clearly on Fed Chairman Bernanke, as this is one of the most highly anticipated rate decisions in recent memory. As a result, range trades will likely prevail for the US dollar on Monday, but Tuesday should see a surge in volatility market-wide, especially if the Fed does the unexpected and leaves rates steady at 5.25 percent.

Euro Stands to Soften as Weaker CPI Limits ECB Rate Hike Prospects
A continued focus on the US side of the EUR/USD pair has kept attention away from news in the Euro-zone, as CPI unexpectedly fell to an annualized rate of 1.7 percent during the month of August, well below the European Central Bank’s 2.0 percent ceiling. While the core measure remains elevated at 1.9 percent, there is far less impetus for the ECB to raise rates 25 basis points to 4.25 percent before year end, despite commentary from ECB President Jean-Claude Trichet that policy remains “accommodative.” In fact, ECB Governing Council Member Yves Mersch on Thursday that the ECB “may resume tightening” depending on the analysis of new data, and at the time of the statement this was widely perceived as being quite hawkish. However, with the new data indicating that price pressures are not as strong as they were previously, Mersch’s rhetoric may signal that the ECB’s tightening cycle has come to an end. Next week, EUR/USD price action will depend very much upon the Fed’s next move, as limited economic data from the Euro-zone will do little to provide a bias for the ECB’s next move.

British Pound Falters as BOE Bails Out Northern Rock
The British pound tumbled on Friday after the Bank of England announced plans to provide liquidity to the UK’s fourth largest mortgage lend, Northern Rock, which was finding it increasingly difficult to access longer term funding. While the BOE’s press release specifically said that that they judged “Northern Rock to be solvent, as it exceeds its regulatory capital requirement and has a good quality loan book," currency traders took off running on speculation that the company will get caught in the classic “borrow short, lend long” squeeze. Furthermore, news reports indicated an all-out run on the bank, as thousands of Northern Rock customers lined up to withdraw their savings from the bank. Even if the current situation in the UK is resolved with a minimal loss of capital, this news indicates that the economy clearly has some severe stress fractures. Moreover, the country’s previously booming housing sector could be ready to take a dive in a similar fashion to that of the US housing sector. As a result, the BOE will be forced to take a far more cautious policy path, and the bank’s monetary policy cycle has likely come to an end with a hike to 6.00 percent before year end effectively off the table.

Japanese Yen Likely to Lose Next Week, Risk Aversion Its Only Hope
As expected, Japanese industrial production was confirmed to have fallen 0.4 percent during the month of July. While this drop was attributed to an earthquake during that period that hit a car parts factory and disrupted output for automakers, the figure is really just another indication that the Japanese economy is suffering amidst concerns that a slowdown in the US will impact export demand. This is one of the primary reasons why Bank of Japan Governor Toshihiko Fukui will not be able go on with rate normalization this year, let alone next week. While many central bankers have shown a clear interest in raising rates from their current 0.50 percent amidst fears of inflation stemming from rocketing land prices and tight labor markets, the fact that headline inflation is negative, consumption remains remarkably weak, and Q2 GDP showed an outright contraction really limits the ability of the bank to hike. As a result, the Japanese yen may continue to soften throughout the week. However, if the Federal Reserve makes a surprising decision on Tuesday and leaves rates unchanged, carry trades could unravel rapidly as risk aversion remains the yen’s only friend.

Kathy Lien is the Chief Currency Strategist at FXCM.