Dollar – Will the Fed Sacrifice the Greenback?
Hardly an auspicious week for dollar bulls as the greenback set yet another record low against the euro hitting 1.3926 on Friday. But follow-through was relatively limited. “The markets remain in a state of flux," we wrote on Thursday. “At this point the currency market is operating under the assumption that the Fed will cut 25bp at next week’s FOMC meeting while the ECB may raise rates another 25bp in October, which explains EUR/USD recent strength. However, those assumptions are far from ironclad and depend to a great extent on the degree that the collapse of housing has affected overall US consumer demand.”

Last Friday’s Retail Sales were hardly a boost for dollar bulls as the number missed expectations printing at 0.3% vs. 0.5%. Still it was not disastrous with the slowdown in retail offset somewhat by robust vehicle sales. The dollar actually came off the lows in the aftermath of the news as the worst fears of a 50bp cut from the Fed began to fade away. Indeed we believe that Fed will cut rates, but only reluctantly and only by 25b. Furthermore, given $700/oz. Gold and $80/bbl oil, inflationary concerns will weigh heavy on the minds of monetary policy makers. Therefore, it's quite likely that while the Fed lowers the Fed rate on Tuesday, it may emphasize that this is a one time event rather than the start of new loosening cycle. The FOMC members are highly cognizant of the precarious state of the dollar and it is doubtful they would want to exacerbate its weakness by sending an overly dovish message to the markets.

After the FOMC rate announcement, the inflation story will be second most-watched report by currency traders this week. With both PPI and CPI data on tap, market players will be quick to respond to any uptick in price data. The Fed finds itself between a rock and a hard place as it must balance the calls for an ease in the credit markets with its need to maintain confidence in the US currency.

Will Euro Take on 1.40 this Week?
The Euro rocketed to a fresh record high of 1.3926 against the US dollar last week amidst commentary from ECB Governing Council Member Yves Mersch, as the policy maker said that the ECB “may resume tightening” depending on the analysis of new data, which leaves the door wide open for a hike to 4.25 percent before year end. This hawkish bias is especially pertinent as it comes on the tails of claims from ECB President Jean-Claude Trichet that monetary policy remains “accommodative.” Furthermore, the ECB said in its monthly bulletin that they will act in a “firm and timely” manner to ensure that risks to price stability don’t materialize and to anchor inflation expectations. However, on Friday we saw that Euro-zone CPI for the month of August eased back to an annualized rate of 1.7 percent – well below the ECB’s 2.0 percent ceiling – signaling that it may be entirely unnecessary for the central bank to tighten monetary policy. As a result, EUR/USD could be in for some widespread selling as traders start to speculate that the ECB’s tightening cycle is complete.

Looking ahead to this week EUR/USD price action will undoubtedly depend on the US Federal Open Market Committee’s rate decision, as global markets are widely anticipating a rate cut, but there is ample opportunity for a surprising announcement. One of the other major factors that could help drive price action for the pair is commentary from ECB members, as their biased rhetoric tends to make an impact on the nation currency. Fundamental data isn’t likely to support EUR/USD, as the Euro-zone trade balance is anticipated to narrow – possibly the result of a stronger Euro quelling demand – while the German ZEW survey of investor sentiment is estimated to decline amidst volatile financial markets and the threat of higher interest rates. Nevertheless, as Technical Strategist Jamie Saettele mentioned in Friday’s Daily Technicals, “we expect a wave 4 correction to end near 1.3784 (38.2% of 1.3551-1.3928 and former congestion) before wave 5 presses against 1.4000… as the trend remains up.”

Yen Traders Pay Little Attention to Abe’s Farewell, BoJ Too?
The Japanese yen was slowly losing its anti-carry, anti-risk appeal last week as volatility in the global markets cooled. However, it was this calm that was specifically unusual since Japan’s Prime Minster Shinzo Abe announced he was resigning as his approval rating slipped below 30 percent. Typically, the political uncertainty from an unscheduled changing of the guard would send both foreign and domestic capital parked in Japanese assets to safer alternatives, be it investments in other Asian nations, western Europe or the US. Clearly, that was not the case this time around. Abe’s bowing out was expected, given his flagging popularity (worsened by various scandals arising from his LDP party) and a vow last week that he would resign should parliament not vote to maintain the navy’s support of US efforts in Afghanistan. What’s more, the departing PM had enacted very little policy that actually helped the economy or trade. Regardless, the search for Abe’s replacement will be on the radar in the days ahead.

In economic news, this past week’s docket was painted in red. Nearly every noteworthy indicator that crossed the wires missed expectations and highlighted the various troubles of the world’s second largest economy. The DCGPI inflation gauge was unchanged for the month, merchant sentiment slipped to a four-year low, and consumer confidence dropped to a three-year low. Perhaps the most disappointing report was the final measurement of second quarter GDP. Annualized growth over the three months ending in June actually contracted 1.2 percent, the biggest drop in more than four years.

Considering recent market conditions, it is difficult to tell whether the yen will bend to swells in risk appetite/aversion or whether volatility will further settle and allow the economic calendar to have its say in price action. There are two clear hurdles for a week of scheduled event risk: the Fed’s rate decision and the BoJ’s rate decision. US monetary policy is seen as the greatest chance at righting subprime fears and stabilizing the credit market (whether these are rational expectations or not is another story). The Japanese bank’s decision is expected to be a non-event; but the possibility of a changing bias keeps fundamental interest alive. For the calendar, the tertiary and all industry activity indexes will generate some interest; but the quarterly BSI confidence survey will be the real market mover for the week.

Pound Traders Cautious as BoE Bail Out Reminiscent of US Troubles
It was an unusual time for event-risk traders looking to play the pound last week. Characteristically top-seated, market-moving indicators were falling on deaf ears and a few of the more mundane reports were actually driving the currency. Perhaps the most disappointing data that is usually prized for its fundamental persuasion came from the labor survey. The claimant count rate for August dropped to a two-year low 2.6 percent as the net change indicator put in for the 11th consecutive contraction in filings. Further adding to the bullish push from the employment data, average earnings growth finally rebounded from a four-month contraction and multi-year low. However, all of these reports came with their own cynical shades: the monthly reductions in jobless claims is slowing; the dip in the rate was expected; and wages are just a tick above multi-year lows. Altogether, this data flow was pretty uneventful. On the other hand, a couple of frequently overlooked housing market reports were garnering an extraordinary amount of attention from the fundamental ranks. The RICS report for August started things off by reporting its first net negative report in 22 months. This indicator is famous for heralding the end of the 80’s property boom. Fear really began to set in when the Rightmove indicator printed its lowest reading since September of 2004. With interest rates higher than those in the US and the most expensive living costs in the world, it isn’t hard to see the UK succumbing to a housing collapse similar to the one seen across the Atlantic.

Looking ahead towards scheduled and hidden event risk this week, one topic likely to be revisited will be the troubles reported with UK mortgage lender Northern Rock. The eighth largest bank and third biggest mortgage provider in the United Kingdom, Northern Rock had to be bailed out by the BoE when credit conditions threatened to ruin the firm.
Interestingly enough, the firm had little exposure to toxic subprime mortgage. The true pressure simply came from Libor rates at their highest level in 9 years. With the BoE only offering meager injections of liquidity (4.4 billion pounds), similar problems may pop up at other British banks and lenders soon enough. With the US housing market causing so much pain globally, the UK’s troubles may look like a second implosion. While traders wait for either Libor rates to take the pressure off lenders or the next bank to come to the BoE, the economic calendar should keep them occupied. Inflation data fills in the Tuesday time slot on the docket. Core CPI is expected to rebound, as is headline RPI. This will certainly be a necessary plug for rate hawks who are loosing ground to lending rate pressures. A little later in the week, the BoE’s minutes will expand upon the MPC’s extraordinary statement following its last decision; and retail sales will tell more than the confidence survey’s could about consumer strength.

SNB - The Unflappable Hawk
There was little going on of any interest to FX traders in Switzerland last week. However, one event that no one missed was the Swiss National Bank’s monetary policy decision. Since the President Jean-Pierre Roth and his fellow policy makers typically convene only once a quarter to deliberate on interest rates, the market has had plenty of time to weigh in on the likelihood and extent of a rate hike. The SNB had until that point been one of the most hawkish central banks in the OECD; however a recent turn in a number of key economic indicators and the wild-fire spread of credit market fears started to erode franc-bulls’ solidarity. Indeed, a week before the rate decision was scheduled to be released, economists were expecting only 13 basis points worth of tightening instead of the standard 25 basis points. Uncertainty was only fueled by the ECB’s decision to leave rates unchanged at its own meeting. Many believe the Swiss bank is merely following in the footsteps of ECB President Trichet and playing off of Euro Zone growth and inflation as keys to forecasting potential price pressures in Switzerland. Therefore, when Trichet overrode his ‘strong vigilance’ cue, there was growing speculation that the Roth would at least ease his forecasts in the policy assessment. The SNB did nothing of the sort, though. Not only was the average three-month Libor rate target raised a quarter point to 2.75 percent, but forecasts for growth held at 2.5 percent while the inflation outlook was raised from 0.8 percent to 2.5 percent, well above the 2.0 percent target.

Looking out at the week ahead, the Swiss franc is in the same position that the yen is in. Either the low-yielding currency will be influenced by risk flows that will play off of the franc’s reserve currency or carry trade status, or calm seas will allow the economic indicators have their go at pushing spot around. For gauging sentiment trends, the FOMC rate decision seems to be the only scheduled risk. Not only is the 5.25 percent overnight lending rate an attractive leech on the franc, but there seems to be a lot of stock behind the Fed’s rate decision having a lot of influence over market volatility. The more easily followed event risk will come from a number of market-moving indicators grouped in the middle of the week. The August trade balance, factory and inflation and ZEW sentiment survey (September) will all have their time in the spot light; but it will likely be the retail sales report and second quarter industrial production indicators that truly move the market. Both business activity and consumer spending are expected to have surged in their respective periods. These numbers will provide the first test of Roth’s bullish outlook on the economy.

Canadian Dollar Sets 30-Year Highs on Record Oil Prices
The Canadian dollar continued its longer term rally through the week, setting fresh 30-year highs against its downtrodden US namesake. Markets pounced on surging energy costs to drive the USD/CAD exchange rate below the psychologically significant $1.0300 mark, with overall momentum promising further declines. Such Loonie gains came on little foreseeable economic event risk, but both Housing and export figures served to improve sentiment on the broader economy. Canadian manufacturing shipments proved a good deal stronger than expected through the month of July, registering their best month-over-month grow since March. Such a result gave hope that a significantly strengthened Canadian dollar had loosened its grip on the broader export industry, and shows that exporters remained resilient through the medium term. Of course, one month does not make a trend, and we will have to see consistent strength to truly prove optimistic on the future of Canadian export-linked industrial growth.

Recent housing data likewise improved outlook for domestic demand, with both Housing Starts and New House Prices coming in above consensus forecasts. New construction on homes recovered from two consecutive months of strong declines, with the key figure growing to a 226,500 annualized pace. Though this was far below the 235,200 rate seen in May, the sudden improvement comes as welcome news to domestic investors. The prices for new homes likewise gained at 0.9 percent on the month—underlining robust demand for real estate. Such bullish housing numbers give hope that strong domestic demand may be enough to offset looming US economic weakness. The Canadian economy clearly stands to lose on slowing growth in its key trade partner, but resilient domestic markets could nonetheless boost the Canadian growth advantage against its southern neighbor.

Upcoming economic event risk will prove especially important for both the Canadian and US currencies, with a critical Fed interest rate decision to generate substantial volatility across all USD pairs. On the Canadian side of the border, we have a combination of key Consumer Price Index data and a later Retail Sales report. Both events are very likely to force large movements in the USD/CAD, with the future of the Bank of Canada interest rate policy hanging in the balance. Markets had earlier expected the BoC to raise interest rates through year end, but it has subsequently become clear that this is exceedingly unlikely. Instead, market rates now predict 25 basis points in rate cuts through year-end. Any disappointments in the data could fuel speculation of imminent rate cuts and push the Loonie off of recent heights.

Aussie Gains Likely to Continue on Renewed Bullishness
The Australian dollar continued to recover from mid-August depths, finishing the week 150 points above Sunday night’s open. The impressive gains highlight improving sentiment for the volatile Asia-Pacific currency, with the CFTC Commitment of Traders report likewise confirming growing bullishness among the speculative community.
Net non-commercial longs grew to 30,744 from 26,520 previously, leaving the trend towards Aussie buying. A relatively positive week of economic data only helped to improved such sentiment, with Consumer Confidence and Dwelling Starts coming in well above consensus forecasts. The former showed that consumers unexpectedly grew more optimistic on future economic prospects, leaving a similarly bullish outlook for the key consumer spending sector. Likewise significant, Dwelling Starts contracted by less than forecast in the second quarter. The net effect was to lift forecasts for the future of domestic-driven expansion, but subsequent outlook for the broader economy will heavily depend on global growth trends and the future of commodity prices.

Limited event risk through the coming week of trade will leave the Aussie at the will of its US namesake, with the critical US Federal Reserve interest rate decision to drive volatility across all USD-linked pairs. Upcoming Westpac Leading Index, HIA New Home Sales, and New Motor Vehicle Sales reports are significantly less likely to force noteworthy moves. It nonetheless serves to note that any especially surprising result out of the Leading Index and Home Sales data could spark unexpected volatility. Otherwise the Aussie will trade off of risk sentiment across global financial markets.

A fairly recent improvement in the carry trade has clearly benefited the high-yielding Aussie, but it remains unclear whether such rate-linked support will last through the medium term. Indeed, global speculators clearly remain on the defensive after a month of incredible volatility across financial asset classes, with expectations for future volatility remaining especially high for currencies. The implied volatility for Australian Dollar currency options remains near 2004 highs. This has historically been a bearish sign for the Asia-Pacific currency, which relies on relatively calm markets to rally against major counterparts. Though the trend remains towards medium term Australian Dollar buying, traders should be wary of any significant worsening in financial market conditions through short term price action.

New Zealand Dollar Gains Dependent Upon Carry Trade Status
The New Zealand dollar kept stride with the other comm dollars, ending last week up 3.2 percent at 0.7130. Economic data supported the gains to a certain degree, as surprisingly strong producer prices – on both the input and output side – kept inflation hawks on edge. Meanwhile, a surge in manufacturing activity highlighted tight capacity conditions. Nevertheless, the Reserve Bank of New Zealand left rates unchanged at 8.25 percent – as was widely expected – after going on a monetary policy tightening spree between March and July, resulting in a total of 100 basis points worth of hikes. The central bank felt that the outlooks for economic activity and inflation have become more uncertain since the last rate increase, and with the policy assessment noting, "Recent inflation outcomes have highlighted widespread inflation pressures, but indicators in recent weeks suggest that previous increases in the OCR are starting to dampen domestic spending, which will help to reduce those pressures," we do not anticipate any additional rate increases in the near-term term. While a sharp decline in the New Zealand dollar in recent weeks should act to support export growth, a decline in household borrowing and turnover in the housing market provide heavy downside risks to consumption. This was only highlighted by surprisingly weak retail sales figures for the month of July, and it appears that when it comes to the New Zealand economy, it’s all down hill from here.

The New Zealand dollar faces very little event risk this week, as only the current account balance and credit card spending are scheduled to be released. As long as carry trades remain in tact, NZD/USD is likely to continue targeting resistance at the 8/27 high of 0.7272 given the pairs high-yielding status. However, the US Federal Reserve’s rate decision on Tuesday provides major event risk for not only the forex markets, but the equity markets as well. If we see that the central bank goes with a surprising decision to leave rates steady, global stock markets will tumble as credit conditions remain tight. This move towards risk aversion will bring traders to invest in safe-haven assets like Treasuries, and pull away from risky instruments (i.e. carry trades). On the other hand, a rate cut (be it 25 basis points or 50 basis points) will serve to not only weaken the greenback, but should give equity indices a substantial boost and keep carry trades like NZD/USD and NZD/JPY in favor.

Boris Schlossberg is a Senior Currency Strategist at FXCM.