Dollar – How Low Will The Fed Go?
50bp or 25bp? That will be the central question facing the market next week. Given the relatively robust NFP reading of 94K – just shy our 100K threshold for a growing economy – the consensus view must side with only a 25bp cut. In fact, if the Fed were to cut by 50bp next week, such a move would almost assuredly be taken as a sign of panic and talk of recession would be quickly revived. For the time being however, fears of a severe US slowdown have been quelled as both ISMs remained above 50 boom/bust line and the jobs data offered no nasty downside surprises.

As we noted on Friday, “Given the massive amount of gloom and doom analysis surrounding the US economy an increase (in NFP’s) of such magnitude would surely silence the dollar bears who have been calling for an imminent start of a US recession. In fact, as we posted in our forums, Google trends indicates that concerns about a recession may be setting a double top in popular media which in turn may coincide with a topping out of dollar negative sentiment.”

Aside from FOMC meeting which will command markets’ attention at the start of next week, traders will likely focus on Wednesday’s Trade Balance figures and Thursday’s Advanced Retail Sales. The Trade number which could surprise to the upside given dollar’s weakness but the Retails Sales number will be key given the fact that the consumer is the cornerstone of US economic demand. The market expects a rise to 0.5% from last months lackluster 0.2% reading. However, recent weekly store data has been mixed at best suggesting that that the credit crunch and the collapse in housing are having a materially negative impact on spending. If Retail Sales once again miss their mark they could spoil the greenback’s near term recovery.

Euro – Trichet Stays Tough
As we wrote on Friday, “Greenback rally… was stopped cold yesterday after a decidedly hawkish press conference from ECB chief Jean Claude Trichet. The message from President Trichet was essentially, ‘Don’t mess with us.’ Mr. Trichet focused squarely on price pressures burbling up in the EZ economy, ignoring the possible dangers of weak consumer spending, suggesting that the ECB was willing to buck the global monetary trend of easing and would hike rates if necessary in Q1. “

Whether ECB would actually follow through on their threats remains to be seem. The economic data out of the region continued to suggest serious bifurcation between producers and consumers. PMI readings last week in both services and manufacturing exceeded their forecasts, but Retail Sales results were woeful. Given the weakness of consumer demand we believe the ECB will remain stationary well into Q1 even if price pressure continue to percolate within the system.

Next week the economic calendar is relatively light with only ZEW and CPI data of any interest to traders. ZEW is expected to deteriorate further but it will likely be the inflation data that could have the most impact on EUR/USD trade. Another hot reading could reaffirm the hawkish posture of the ECB, but the print would have to be extraordinarily high in order for traders to consider another ECB rate hike in the near future.

USD/JPY May Plummet Despite Further Deterioration in Japanese Data
The Japanese yen weakened over the course of last week, and as usual, economic data was generally disappointing. Capital spending in Japan fell for the second quarter in a row during Q3 at a rate of 1.2 percent, following a drop of 4.9 percent during the period prior. While industrial production figures have shown that exports remain strong given resilient demand from China and Europe, fears that a slowdown in the US economy will negatively impact Japan continues to grip businesses and as a result, they have cut back investment in their own firms. Furthermore, the capital spending report negatively impacted the revisions of Q3 GDP figures, as the initial estimates were based on the assumption that corporate expenditures had improved 1.7 percent. Indeed, annualized GDP was revised down to 1.5 percent from 2.6 percent, and residential investment also helped drag down this figure, as a 35 percent drop in housing starts was so severe that it led the Bank of Japan cut its GDP forecasts for the current fiscal year to March 2008 to 1.8 percent from 2.1 percent. This doesn't little to help the case of BOJ Governor Toshihiko Fukui, who has long called for additional rate normalization. Nevertheless, with prices teetering on the edge of deflation, consumption remaining weak, labor market conditions deteriorating, and businesses reflecting some slowing, the BOJ would likely be doing more harm than good to the Japanese economy by raising rates from 0.50 percent.

This week, the biggest event risk for the yen comes on Thursday, as the BOJ's quarterly Tankan survey is expected to reflect a slowdown in the manufacturing and a slight pickup in capital expenditure growth. Nevertheless, the yen may have an opportunity to gain this week, as risk aversion trends remain the primary driver of the low-yielding currency. As a result, traders should keep an eye on global stock markets, as a plummet in equities could push USD/JPY back down towards 109.00.

Can Cable Hold Above Critical Support at 2.02?
Last week we questioned whether the Bank of England would opt to cut rates in December, and indeed, they did. The BOE cut rates by 25bp to 5.50 percent for the first time in more than two years, in line with what futures markets were pricing in but against consensus estimates of economists polled by Bloomberg News. In the bank's policy statement, the MPC noted that signs had emerged that growth has started to slow, and that downside risks were mounting as "conditions in financial markets have deteriorated and a tightening in the supply of credit to household and businesses is in train." Meanwhile, the BOE judged that inflation would hold above target in the short-term, but that a slowing of demand growth would pull inflation "back to target in the medium term." The minutes of this meeting will be published on December 19, but with Cable bouncing from critical support at 2.02 following the decision, the markets have judged the BOE's statement as somewhat neutral as the MPC is not likely to continue easing monetary policy in January given inflation risks.

Looking ahead to this week, the inflation issue may come to the forefront once again on as UK input and output costs are forecasted to rise strongly. Indeed, PPI input is expected to surge 9.3 percent from a year ago while PPI output is predicted to gain 4.2 percent from a year ago – the sharpest rise in twelve years. The data not only suggests that broad price pressures are mounting, but also that companies are feeling the squeeze on their profit margins as they are unable to pass through the increased costs to their customers. However, this may be one of the only releases that will support the case for further GBP/USD gains, as housing data is anticipated to prove very disappointing while trade balance figures could reflect softer exports on the back of the stronger British Pound. Overall, the most important factor for Cable bulls is whether or not the pair can hold above major trendline support at 2.02, as a break lower would suggest that additional losses may be in store.

Franc Falls Back to Support as SNB Decision Approaches
The economic winds died down in Switzerland last week and so did the demand for a safe haven currency. Last week’s major sources for market wide event risk proved to be a let down for volatility traders and Swiss bulls. The week opened with the uneventful Gulf Cooperation Council’s Doha summit. The primary topic of discussion: whether the Middle Eastern oil producers would diversify away from the dollar. However, with Saudi Arabia refusing to break its peg to the greenback, this potential event risk officially fell flat. Later in the week, the persistence credit market disruption (a common driver for the carry trade ebb and flow) was dealt a blow when US President George W. Bush announced a proposal that could help out as many as 1.2 million Americans with subprime loans by freezing their rates for five years. However, while the US subprime market was the source of the global credit markets ills, it remains to be seen whether a fix there can piece together shattered confidence among international lenders. Finally, turning from the risk to yield component of the carry trade, the burden of being a funding currency was lightened when both the Bank of Canada and Bank of England announced quarter point rates cuts. Now, with three major central banks officially lowering their rates, it seems as if the global trend of higher interest rates is coming to an end – and perhaps with it, the carry trade.

Shifting the focus over to the scheduled fundamental event risk taxing the franc’s tranquility this past week, there were only indicators on the docket. Monday brought the SVME purchasing managers index for November. The three-month high in manufacturing was unexpected given the swissie’s record high against the benchmark dollar and weakening consumer spending trends from Switzerland’s major trade partners. Nonetheless, output, orders, and employment components all improved, while inventories contracted – all promising steady activity through the year’s end. Thursday’s November labor data proved to be a non event as the seasonally adjusted figure held its five-year low 2.6 percent. On the other hand, with the unadjusted rate ticking higher for a second month, the top may have already been put into place.

Scheduled event risk and general risk trends will play into swissie action once again this week. From the economic calendar, the ZEW investor sentiment survey will be simply fill in the time until Thursday’s SNB rate decision. The Swiss central bank has lifted its three-month Libor target rate by 25 basis points at its last eight consecutive quarterly policy meetings. The December meeting is expected to break that trend with the ECB holding rates steady since June and domestic growth trends expected to cool thanks to fading demand from major trade partners and little risk to heightened inflation pressures. Speaking of interest rates, the FOMC rate decision could send ripples throughout FX market. With debate raging between a 25 and 50 bp cut from the Fed, carry traders will be watching intently.

Canadian Dollar Regains Traction on Employment Results
The Canadian dollar finished lower for the fifth consecutive week of currency trading, but a significant reversal raised prospects for a further Loonie bounce through upcoming price action. Indeed, it seems as though the USD/CAD ran out of steam through mid-week trading, as the currency pair reversed at the confluence of a significant Fibonacci retracement level, 100-day moving average, and 9-month trendline near the 1.0200 mark. (For more on USD/CAD technicals, click here) Short-term momentum subsequently remains in the Canadian dollar’s favor—especially as recent employment data points to robust domestic labor growth through the month of November. The currency had previously lost on an unexpected interest rate cut from the Bank of Canada, with analyst forecasting that a slowdown in expansion would lead the BoC to continue cutting interest rates through 2008. Yet continued signs of above-trend economic growth would clearly dampen fears of a deterioration in Loonie yield differentials, and earlier Building Permits data and Ivey PMI results suggested that growth remains robust across the broader economy. Such trends leave the Bank of Canada with little room to maneuver if it hopes to ease monetary policy further through 2008.

The coming week may prove critical for the USD/CAD currency pair, as key Canadian economic reports and the highly anticipated US Federal Open Market Committee rate decision promise strong volatility through short-term trade. Speculators will hit the ground running with Monday morning’s Housing Starts result, while key International Merchandise Trade data on Wednesday and Manufacturing figures on Thursday likewise provide significant Loonie event risk. Yet the US FOMC rate decision on Tuesday may provide the sharpest USD/CAD volatility—especially as markets are unsure on whether to expect a 25 basis point or 50 basis point interest rate cut from the American central bank. Any surprises out of the release could very easily drive strong volatility across all USD-linked pairs. Given the Canadian dollar’s historically strong correlation to US dollar performance, the news could likewise drive CAD moves against other major forex counterparts. Short-term momentum remains in the Loonie’s favor, but any disappointments out of key economic releases could easily reverse such movements. Otherwise, our short-term bias remains to the downside for the USD/CAD currency pair.

RBA Holds Fast, Australian Calendar Busy Once Again
The Australian economic calendar was jam-packed last week. Indicators on the docket ranged from sector performance reports, inflation, trade, spending, housing, corporate profits, growth to interest rates. The heavy hitting surprises began relatively early in the week. Early Monday morning, the simultaneous releases of the October trade and third quarter corporate operating profit reports roused fundamental bears. According to the government statistics group, the nation’s trade deficit ballooned to a record A$2.98 billion shortfall. Considering the Australian currency’s meteoric rise over the past few quarters, the bottleneck at national ports, strong consumer spending and the disparity in exports, it seemed only a matter of time before the trade account deteriorated. Corporate profits looked to share in these unfavorable conditions. The business sector reported a net 2.1 percent drop in operating profit over the third quarter, the biggest decline in four years. As the week wore on, a five month low in retail sales, the biggest drop in building permits and a modest improvement in service sector activity bided traders’ time before the main event – Wednesday’s RBA rate decision and the third quarter GDP report. The market was watching the rate decision with particular interest as the BoC had lowered its own rate a quarter point just the previous day (at the time just the second major central bank to do so). Ultimately, there was no change to the benchmark, but the policy group broke trend tradition when the released a statement. In the brief, Governor Glenn Stevens suggested upside risk to inflation with CPI rising above 3 percent in the first half of 2008 before easing below the tolerance barrier later in the year. The GDP was a mixed bag as the economy grew 1.0 percent over the previous quarter (in line with expectations) while the annual rate hit a three year high 4.3 percent, though it still fell short of forecasts.

Looking at the fundamental offerings ahead of us, there are a few second tier numbers and one top market mover; but the economic dial has clearly been dialed back from last week. The NAB confidence and outlook numbers for November will give an update on the health of the business sector. With the Aussie dollar hitting news highs in November and commodity prices rallying to record highs over the same period, even the leading mining and export sectors will come under pressure. The following day, Westpac will release its measure of consumer confidence for the current month. And, as lending rates are still high, the price at the pump is breaching new records and the economy is growing unevenly, another slip into pessimism is the likely outcome. Finally, Thursday morning’s employment report will stand as key event risk for the week. Expectations are set close to the trend that we have been seeing from the series for the past few months. A 20,000-person jump in payrolls last month is expected to keep the jobless rate at its three decade low 4.3 percent. This indicator is often a better reading of consumer spending and sentiment than even the confidence report.

New Zealand Dollar Rallies on Hawkish RBNZ Rhetoric, Rate Prospects
The New Zealand dollar gained for the third consecutive week of currency trading, as a surprisingly hawkish central bank gave fresh reason to buy the commodity-linked currency. The Reserve Bank of New Zealand left record-high interest rates unchanged through their recent meeting, but surprised markets with aggressive rhetoric on inflationary prospects. Analysts had previously forecast that the RBNZ would cut its key Overnight Cash Rate through the first half of 2008, but the bank’s statement shot down such hopes and boosted outlook for domestic yields. The Kiwi subsequently rallied on forecasts that its impressive rate advantages would remain unchanged or improve through the months ahead—especially as several key central banks have recently begun cutting their own policy rates. The calendar was otherwise empty for the high-yielding Asia-Pacific currency, but event risk will intensify in the week ahead on several important economic release.

The clear highlight on New Zealand’s calendar will come from Wednesday evening’s Retail Sales report, while earlier House Prices and Food Price inflation numbers may likewise force volatility across NZD pairs. Consumer retail spending surged 1.0 percent in the month of September, raising fears that excessive consumption would boost domestic inflation rates. A similar result in the upcoming Retail Sales release would give reason to believe that the Reserve Bank of New Zealand could take an increasingly aggressive stance against price pressures. The NZD yield curve shows that markets have priced in a modest probability of rising interest rates through the coming six months—a clear departure from a previously inverted yield curve. Otherwise, traders are likely to watch for any surprises in Tuesday’s Food Price inflation reports, Sunday’s House Prices data, and Thursday’s Manufacturing Activity results. Though these reports do not typically force major volatility across NZD pairs, recently hawkish RBNZ rhetoric may shift focus towards individual releases in order to gauge interest rate prospects. Currency markets will likewise react to any shift in global risk sentiment—especially as seen through the performance of risky asset classes through the upcoming US Federal Reserve interest rate announcement.

Boris Schlossberg is a Senior Currency Strategist at FXCM.