Volatility dominated the dollar landscape this past week, but direction was notably absent. However, looking at the building fundamental pressure behind the ongoing financial crisis - and the expectations for rate cuts that have been laid bare by this uncertainty – the potential for breakouts across the majors is material. First and foremost, fundamental greenback traders’ main concern in the days ahead will be the progress of the proposed bailout plan. The necessity of this financial market rescue couldn’t have come at a worst time as politicians bidding for control of Washington have held up this vital piece of legislation due to concerns that a signature on this bill would draw the resentment of constituents. However, the longer it takes to pass a viable plan, the more likely it becomes that another major bank will be forced into bankruptcy. What’s more, with Washington Mutual just another casualty of the market crunch (since the bailout was proposed), the threat of another infectious panic is certainly growing.

On the other hand, even if Congress can hammer out the details of a financial rescue, they may still come up short of reviving lender and investment confidence. In most of the major failures that have resulted from the subprime meltdown, the final nail in the coffin has come from a panic withdrawal of deposits and capital as opposed to business-ending losses. Therefore, the perception of stability and low counter-party risk will need to spread into the global markets to truly take effect. However, even if these immediate fears are purged, we are still left with the long-term economic consequences of this crippling period. Many market participants had believed the US economy was heading for a recession even before this fundamental stress was added. In recent weeks, the bears have certainly multiplied. These dour growth forecasts have further boosted the probability of rate cuts – dramatically. Fed Fund futures are fully pricing in a 25bp rate cut for the October 29th meeting and there is a 32 percent chance that the central bank will act by slashing the benchmark by half a percent.

While the financial crisis and rate expectations will be two, overwhelming influences on the US dollar for some time to come, the economic calendar will offer more of a regiment to event risk. Topping the list of indicators due for release is the monthly non-farm payrolls report (NFPs). This indicator has been put on the back burner recently, but an expected ninth consecutive contraction would draw further comparison to the employment conditions back in 2001/2002 – during the country’s last recession. Other indicators will offer a broad gauge of economic activity through the third quarter. Consumer spending (which accounts for an estimated 80 percent of US growth) will be measured through personal consumption expenditure, personal income and personal spending indicators. Other growth readings will come in the form of the ISM manufacturing and service sector reports – both readings are expected to have contracted through September.

Written by: John Kicklighter, Currency Strategist for DailyFX.com

Euro Forecast Against the US Dollar Depends on ECB, US Treasury Bailout

Forecasts for the Euro/US Dollar Exchange rate took a turn for the worse, as a steady stream of bearish economic data dimmed outlook for the broader Euro Zone economy. The EURUSD finished marginally higher through the week’s close despite a deterioration in economic outlook, but this was largely a function of broader US dollar weakness. When we look at fresh fundamental developments out of the EMU, we see that German IFO consumer confidence fell yet again, and Ireland became the first EMU economy to officially enter two consecutive quarters of negative GDP growth. Though the former “Celtic Tiger” is not necessarily comparable to other major European Monetary Union states, many believe that it will only be the first of several countries in the EMU to enter technical recessions. Such pressures may leave the European Central Bank with little choice but to ease interest rates in a bid to boost flagging European growth rates.

The coming week will go a long way in clarifying outlook for European interest rates and the euro, with a European Central Bank interest rate decision to drive market volatility through late week trade. Analysts widely forecast that the ECB will leave rates unchanged in their Thursday morning announcement, but Overnight Index Swaps are actually pricing in an approximate 20 percent chance that the ECB will cut rates by 25 basis points. Market indecision ahead of the event will likely make for volatility regardless of the outcome, and it will be very important to listen to any shifts in rhetoric from ECB Governor Jean Claude Trichet.

Trichet is known for being quite candid with the ECB Governing Council’s stance on interest rates, and we cannot rule out the possibility that he will signal rate cuts through upcoming meetings. A recent drop in German Consumer Prices arguably gives the ECB breathing room as far as inflation is concerned, and dimming domestic growth prospects will only increase political pressure on the ECB to cut borrowing costs. A dovish turn in ECB rhetoric would likely cause a noteworthy selloff in the EURUSD.

Otherwise, euro traders will need to watch developments out of the US economy. Market indecision surrounding the US Treasury’s plan to bail out credit markets will continue to drive sharp price moves in the USD, while the infamous US Non Farm Payrolls report will likewise force major dollar volatility through end-of-week trade.

Written by David Rodriguez, Quantitative Analyst DailyFX.com

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