US Dollar Strengthens as PPI and Retail Sales Question the Validity of Recession Calls
Is a recession in the US economy in 2008 possible? Yes. Is it probable? No. Before the FOMC rate decision on Tuesday, a poll by WSJ.com put the chance of a recession at approximately 35 percent. Yesterday’s coordinated announcement by central banks around the world did little to alter those expectations, but taking a look at today’s US data, it is hard to believe that a recession is probable. The US consumer, who is the backbone of the economy, continues to spend voraciously. According to the retail sales report, consumer spending doubled expectations in the month of November thanks to exceptionally strong demand for clothing and electronics. We are also finally seeing the impact of energy prices on inflation as producer prices grow by the fastest pace in 34 years. These reports are the main reason why the Fed did not cut rates by more than 25bp on Tuesday. Their hands are tied when it comes to monetary policy which is why they have been forced to come up with more creative ways to prevent the credit squeeze from worsening such as creating a Term Auction Facility. It can be argued that today’s data is horribly backwards looking and the US economy is simply catching up with the rest of the world when it comes to inflation, but the strength of the US consumer cannot be overlooked. Analysts are notorious for being overly pessimistic as they have been about the Euro’s impact on the Eurozone’s economy. We had a record breaking Black Friday and Cyber Monday which should have been a good indication that retail sales in November would be strong. Consumer prices and industrial production are due for release tomorrow and we expect consumer prices to follow producer prices higher.

Time for a Rally in Carry Trades
The Japanese yen crosses gave back some of yesterday’s gains but that does not mean that the carry trade rebound is over. The Dow Jones Industrial Average staged a very impressive intraday rally, having been down as much as 120 points around 2pm ET. So far, the financial markets have not had the reaction that central banks may have wanted from yesterday’s big announcement which suggests that these central banks could have more tricks up their sleeve. The $40 billion in special loans is not a lot, but the first coordinated by central banks from around the world since September 2001 indicates the severity of the credit squeeze in the eyes of global policy makers. They are testing the waters to see if banks will respond to the cheaper liquidity. If they do not, we could see more attempts at finding creative ways to inject liquidity into the financial system and boost investor confidence. For the currency market, this means a possible rebound in carry trades thanks to a continual rally in US equities. The Japanese Quarterly Tankan report is due for release tonight. In the past, this report has been very market moving, but in recent quarters it has lost its impact on the yen because business sentiment has done little to give the central bank more or less reasons to raise interest rates. We expect the Tankan to be weaker because consumer sentiment continues to fall and borrowing costs continue to rise giving Japanese businesses little reason to be confident.

Why is the Euro Weaker?
Despite stronger than expected inflation in France last month, the Euro dropped to the lowest level against the US dollar this week. The primary culprit of the weakness was undoubtedly dollar strength since US data dominated the economic calendar today. Although the Euro has spent the second half of the US trading session clawing its way back, trading tomorrow should continue to be dominated by US data. Eurozone consumer prices are also due for release and hot numbers are expected, but that should not be much of a surprise since the European Central Bank has repeatedly warned that the risks to inflation is to the upside. The ECB was extremely hawkish last week and the CPI numbers will only validate their bias. US numbers on the other hand are a bit surprising since the Fed has been focusing much more on growth than inflation. This seems to be the stance that the Swiss National Bank holds as well. They left interest rates unchanged at 2.75 percent for the first time in 2 years. Concerns about global growth outweighed their worries about inflation; even though they raised their inflation forecasts for next year, they lowered their forecasts for 2009.

Sharp Deterioration in RICS Weighs on British Pound
The British pound came under the weight of dollar strength and weaker UK economic data. The RICS house price balance dropped by the biggest amount since May 2005, reflecting the overall deterioration in the UK housing market. There is no UK data due for release tomorrow which means that the fluctuations of the GBP will continue to be contingent on demand for US dollars. We don’t expect any pound driven movements until next week at the earliest.

More Losses for the Australian, New Zealand and Canadian Dollars
To the surprise of the market, Australian employment increased 52k last month which was the strongest pace of job growth in six months. The unemployment rate increased from 4.4 to 4.5 percent but the labor market remains very tight as the rise simply reflects more people joining the workforce. Overall the Australian economy is strong which is why the central bank raised interest rates to an 11-year high last month. USD/CAD on the other hand hit a 3-month high following mixed Canadian data; new house prices fell short of expectations but manufacturing shipments and labor productivity improved. Despite the economic reports, broad dollar strength has weighed on all of the commodity currencies along with softer gold and oil prices.

Kathy Lien is the Chief Currency Strategist at FXCM.