Fed Forced Back to Easing Mode

The unexpected 0.3% decline in US August retail sales and the 0.9% decline in August PPI suggest that inflation pressures may be heading in the same direction as economic growth, thereby shutting the door on any rate hike probabilities, and providing the Fed with room to consider shifting back towards an easing bias. We mentioned earlier this week that the historic government takeover of Fannie/Freddie was a prelude to the Feds moving back towards an easing bias next week. Todays economic reports marked the data confirmation for such a move, which will be demonstrated in an accentuation of the downside growth risks in the policy statement.

Considering that the only sources of rallies in Wall Street have been government-led interventions (Taking over of Fannie/Freddie, Treasury/Feds assumption of finding a buyer for Lehman) underlines the paucity of positive dynamics in the economy. Prolonged uncertainty in the banking sector, deteriorating US consumer fabric, rising unemployment and looming escalation in the US budget deficit confirm that the dollar rally has little to do with improved US fundamentals and mostly with weaker conditions overseas as well as the intricacies of positions unwinding. Such asymmetry in foreign exchange valuations may lead to a substantial whipsaw and a partial unwinding of the latest dollar rally once the Fed is forced to cut interest rates (our benchmark view since the temporary pause began in June.
Euro Bounce Finds Fundamental Momentum

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USDJPY Eyes 106.60

Yen rallies anew after initially having fallen across the board in the Asian session following yesterdays Washington Post report revealing that the US Treasury and Federal Reserve will assume the task of finding a viable buyer for Lehman Bros. This has led to a last minute rally in Wall Street on Thursday, giving rise to gains in high yielding currencies GBP, AUD, NZD, all at the expense of the JPY and CHF. But this mornings combo of weak growth/weak inflation underscore that growth is increasingly becoming the priority instead of inflation. USDJPY is seen extending losses towards 106.60, backed by 106.00.

WARNING: Although the dollar may have a tough session ahead in todays trade, we warn of the possibility of an announcement later in the day that a viable buyer for Lehman has been found, which could trigger similar shot in the arm for risk appetite as was the case in last Fridays Fannie/Freddie announcement (which also took place at the same day of the release of dismal economic news).