The USD recovered broadly against other major currencies this week as the GSE panic subsided further and oil and other commodity prices continued their sharp retreat. US 2Q bank earnings reports also came in generally better than expected, though many firms still reported significant losses and write downs, but left the impression that financial sector hemorrhaging is nearing an end. Non-financial firms' 2Q earnings reports were also generally better than expected, reinforcing the notion that US firms are well-positioned to weather the current economic storm, with attendant positive implications for the US economic outlook

In short, the US outlook continues to stabilize while fresh signs of deterioration are appearing in other major economies' outlooks, particularly in Europe and the UK.  Hawkish Fed rhetoric (FOMC minutes, Stern and Plosser) has increased expectations of a Fed rate hike in the fall-Fed Fund futures now reflect a nearly 50% likelihood of at least a 1/4% increase in US rates at the September 16 or October 29 meetings. Increased US rate hike expectations, coupled with the sharp declines in commodity prices (stemming from overall slower global growth and demand, e.g. China's 1st half 2008 steel exports fell sharply), are dovetailing to support the USD. We are more optimistic than in many months that the US will avoid a recession and that in a few months time we'll look back at July 2008 as the significant low point for the USD.

While we are significantly more optimistic that the worst-case scenario in the US and for the USD will be avoided, we would remind traders of the highly uncertain outlook both here in the US and globally, as well as recent range-bound trading conditions that have dominated FX markets this summer. Take it one step at a time. At the same time, we are very encouraged by the persistence of the USD's recovery this week-pullbacks were minimal and the USD is closing nearer to its highs for the week. We view such persistent price moves as an indication that markets were are not positioned for a USD rebound, and consequently had to chase the buck higher, limiting any pullbacks. That also suggests additional flows are likely to come into the USD in the weeks ahead, as shorts continue to unwind and long positions are established. The inverse relationship between commodities (oil still the key) and the USD (commodities down/USD up) continues to be the most visible trading correlation at the moment and will remain a key driver of USD. A WTI oil price drop below the $119-122/bbl support zone is the trigger for further steep losses, likely to the $100/105 area.

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