Dollar – Recession Coming?
Not a happy start to a New Year for dollar bulls as US data turned decidedly dour last week ending on a depressing note of very weak NFP print of only 18K jobs. The job picture, which was the last bastion of relative strength for dollar longs is now a very serious cause for concern. If US labor environment begins to deteriorate the Fed will be forced to ease unremittingly at least through the summer doing further damage to the greenback as interest rate differential with the euro continues to compress.

On Friday, the dollar’s only source of solace was risk aversion as the Dow slipped by more than -200 points and forced carry trade liquidation in the high yielders keeping the buck relatively buoyant. However, that dynamic may not last for much longer if the market becomes convinced that the risk of US recession is real. Under that scenario the greenback is likely to fall irrespective of equity flows as speculators anticipate a series of rate cuts from the Fed.
This week the US calendar is relatively tame with Pending Home Sales and Trade Balance data the only key markers on the docket. One key data point that may receive more attention than it usually gets is the Consumer Credit survey report. The market anticipates a large expansion to $8.5 Billion but if the number fails to meet its forecast it will serve as yet another piece of evidence that the US consumer is slowing markedly and the line between a slowdown and recession will only become thinner as the woes in US housing finally begin to impact the broader US economy.

Euro – Still Hawkish
Could we really be in the midst of de-coupling? While the US data continued to be horrid this week, the news from the Euro-zone was essentially positive. German unemployment rate slipped further down to 8.4% from 8.5% expected as the biggest economy in the region continued to perform well. Additionally both PMI Services and Manufacturing gauges remained comfortably above the 50 boom/bust level albeit the services component slipped slightly below expectations. Overall however, the Euro-zone economy showed much better strength than its US counterpart so much so that ECB member Orphanides warned that they are ready to raise rates if needed because the current inflation projections are too optimistic.

As our colleague Kathy Lien noted on Thursday, “With economic growth steady, the (ECB) focus will continue to be on how much second round effects will be caused by the recent rise in oil prices. Originally we did not expect the ECB to actually follow through with an interest rate hike next year because we believed that inflation rates would stay steady and slowly begin to fall. As long as the ECB remained hawkish, that would be enough. However now that inflation is on the rise, if the pressure refuses to abate, the ECB may be forced to put action behind their words even if they do not want borrowing costs to rise once again.”

Next week the EZ economic calendar may carry further news of creeping inflation as PPI readings are expected to rise to 0.8% from 0.6% the month prior. A hotter than expected result would only stoke speculation of possible ECB tightening and would stand in stand in stark contrast to the easing expectations from the Fed. That contrast may grow even sharper if EZ Retail Sales due Tuesday show a marked improvement from the month prior when they printed negative for the first time in four months. In short the EZ data looks to improve while US data continues to deteriorate, and that dynamic suggests further euro strength.

Risk Aversion Remains the Yen's Only Ally
The Japanese yen surged for the third consecutive week as risk aversion remained in play and stocks tumbled. Indeed, it's no coincidence that the Dow Jones Industrial Average fell in tandem with yen pairs like USD/JPY during the first three trading days of 2008. Japanese economic data has had little bearing on the Japanese yen, especially as there is almost no chance that the Bank of Japan will adjust monetary policy anytime soon.

While the Japanese financial markets have not been roiled to the degree the US, UK, and European markets have in the midst of a credit crunch, they are not entirely in the clear either. Indeed, with consumption growth remarkably weak in Japan, the country has become ever more reliant on capital spending and exports. However, both of these areas have proven to be soft spots as of late, and with global growth expected to slow in 2008, there is little evidence to suggest they will improve significantly. This week's economic data may highlight this, as the Leading Economic Index is forecasted to ease to a paltry 10 percent from 18.2 percent – indicating dour growth prospects in the future - while the Eco Watchers survey is anticipated to hold well below 50, which points to broadly pessimistic sentiment amongst workers. Nevertheless, risk aversion trends and the status of the US Dollar will be the main driver of USD/JPY, and as Technical Strategist Jamie Saettele pointed out in Friday's Daily Technical Report, the pair could be in for a bounce in the near term.

Cable Faces Downside Risks on BOE Rate Decision
Ever since the Bank of England cut interest rates in December and the minutes of the meeting showed that the monetary policy decision was a unanimous one, the British Pound has essentially only moved one way: down. Indeed, GBP/USD has broken through major trendline support and the psychologically important 2.00 level, highlighting the bearish declines in the pair despite recent improvements in UK economic data. Services PMI surprisingly rose to 52.4 from 51.9 on the back of gains in new business, employment, and prices, while Construction PMI jumped to 56.0 from 54.3 on solid commercial building growth. However, both releases were tinged with sour outlooks, as business expectations in the services sector faltered while construction PMI reflected a reduction in residential building activity for the first time since August, 2006. Meanwhile, Manufacturing PMI slipped to 52.9 from 54.3 on faltering production and orders, and with global growth widely anticipated to take a hit in 2008, the data does not bode well for the UK economy as both domestic and foreign demand stalls. Despite the fact that some of last week's reports showed improvement, the underlying issues of dour growth outlooks for 208 allows the Bank of England room to be less stringent in regards to monetary policy, and raises the chances that the central banks will move to cut rates in 2008. The big question is, will we see a rate cut this week?

According to a Bloomberg News poll of economists, no. The Bank of England is widely expected to leave rates steady at 5.50 percent after surprisingly cutting by 25bp in December. While there is some risk that they will ease rates once again, the monetary policy decision may prove to be a non-event, as statements are not issued when no change is made. Nevertheless, traders should keep an eye on any subsequent commentary by various monetary policy committee members, especially Governor Mervyn King or über-doves like David Blanchflower, as this may steer directionality in the pound pairs. The release of Nationwide Consumer Confidence, the Visible Trade Balance, and Industrial Production all provide downside potential for Cable as well, and as long as the pair holds below 2.01, a break down towards 1.9550 would not be entirely surprising.

Swiss Franc May Have More Steam for a Push Below 1.10
The Swiss franc gained throughout the week as risk aversion continued to play on the low-yielder's favor. Meanwhile, economic data out of Switzerland was broadly mixed. Conditions in the Swiss manufacturing sector deteriorated slightly in December, as SVME PMI eased back to 61.3 from 63.4. A breakdown of the index shows that output actually held steady, and while the backlog of orders and quantity of purchases fell - pointing to a slowdown in demand – the resilient output suggests that businesses either remain optimistic about growth in 2008, or they are producing too much and will be faced with mounting inventories in coming months. Meanwhile, Swiss CPI grew 0.2 percent during the month of December, pushing the annual rate of growth to a 12-year high of 2.0 percent on the back of energy price gains. Indeed, Swiss National Bank President Jean-Pierre Roth said in mid-December that rising energy prices would "likely" push inflation above the bank's 2 percent ceiling in the first half of 2008 for the first time in nearly 13 years, though he indicated the rise would be "temporary" in nature. The SNB anticipates that slowing economic growth will put a cap on building price pressures, but with oil and other commodity costs skyrocketing as we start out 2008, softer expansion may not do the trick and the central bank may consider enacting one more round of rate normalization this year. However, this may only be possible if the instability in the financial markets dies down.

Event risk for the Swiss franc this week will be at a minimum, with on the unemployment rate scheduled to be released. The figure is anticipated to hold steady at 2.6 percent, though an unexpected rise would not bode well for consumption outlooks in the country. On the other hand, a surprise tightening in the labor market could give the Swissie a short term boost. From a technical perspective, risk remains to the downside for a move below 1.10.

Is the Fundamental Floor Falling Away for the Canadian Dollar?
Through all the ups and downs in liquidity last week, the Canadian dollar held a relatively consistent bearing: down. Through the first half of the period, an empty calendar gave free reign of USD/CAD price action to market interest in the greenback. However, looking over the other Canadian dollar crosses over the same period, there was remarkable drop in nearly all the currency’s pairings. This selloff in the absence of Canadian-specific data seemed even more unusual considering the strength in commodities. In years past, USD/CAD (among other loonie pairings) has enjoyed an on-again, off-again correlation to raw materials as shipments of these necessary goods comprise a bulk of exports. Therefore, it unusual that this relation has not come back as key Canadian commodities are pushing to extremes – like crude hitting a record high just above $100/barrel and gold marking a record just north of $870/ounce.

The fundamental winds behind the loonie’s selloff began to pick up around Wednesday; though the first wave happened to come out of the US. While the dollar was dealt a heavy blow from the worst reading on US business sector activity in four and a half years, the data boded just as poorly for the Canadian economy. Whereas economists were met with another potential cause for an impending recession for the world’s largest economy, loonie traders saw a sharp drop in demand for raw materials from one of its largest consumers. It wasn’t until Friday, that the Canadian docket was finally roused to life. The generally overlooked industrial product and raw material price indexes garnered a closer look for their November reading. The input price report jumped 3.4 percent, though when the 9.7 percent jump in fuel costs were excluded, the indicator actually fell 2.8 percent. More interesting though was the first increase in the industrial product figure (an output price measure) since April. As the Canadian dollar has risen, manufacturers have been unable to pass the burden of higher costs onto the consumer. Should this turn into a trend of higher prices, the BoC may find it difficult to pursue further rate cuts in the future. While this was an interesting turn of events, the top market mover proved to be the Ivey PMI report for December. Dropping to its lowest level in six years, this indicator perhaps stands as irrefutable proof the business sector is struggling with the high currency and waning US demand.

As liquidity continues to fill out and the first full week of FX trading of the new year gets under way, loonie traders will have more data to work with. The calendar picks up again in the middle of the week with a trio of housing indicators. Housing starts for December and new home prices and building permits for November will offer a full review of activity in the residential market. And, while this sector has not found as much market interest as say the manufacturing group, as a key measure of consumer wealth and lending conditions, it could easily be ushered to the forefront should the data surprise. Friday holds the greatest risk for big moves over the entire week with December’s employment data and November’s physical trade report. Rough readings of domestic demand and foreign demand, these two reports could redirect growth forecasts.

Data Supported Aussie Dollar, While It Lasted
The Australian dollar held strong through most of this past week as a busy economic calendar kept the currency in the green. Unlike many other light economic dockets, Australia’s calendar produced a market worthy release Monday. While the private sector credit report is usually considered a second or third rung indicator, its November print boosted it to first class. The Reserve Bank of Australia reported a 1.7 percent jump in borrowing over the month – falling just short of the multi-year record 1.9 percent figure five months ago – while the year-over-year number accelerated to its fastest pace since 1989. According to the central bank, both businesses and consumers were responsible for the jump. Australian manufacturers have been borrowing money in an effort to expand their production capacity to a backlog of orders. At the same time, flush with cash and confidence in the economic outlook, consumers took on 0.8 percent more credit to pay for homes and 1.7 percent for other purchases. Not only does this data suggest growth - and the forecast on expansion - stand on firm ground, it raises the specter of oppressive inflation that will require further rate hikes from the central bank. Later in the week, the outlook on the health of the economy only improved. The AIG Performance of Manufacturing index jumped to a five-year high for December as the sector marked a 19th consecutive month of expansion. And, a closer look at the breakdown revealed the while total orders rose over the period, export bookings actually dropped significantly, suggesting that the high currency and cooling global growth trends are weighing on exports, but also that a strong domestic economy would fill in for any shortfall. Producing a similar jump in Aussie bullishness, the AIG services number marked its own three-year high as Christmas shopping at retailers boosted activity.

With such a steady clip of impressive data, the Aussie dollar was set to close a relatively strong week against its major counterparts. However, this happened to not be the case as a steep selloff overtook all of the Aussie crosses. It was clear that the economic calendar wasn’t responsible for the nearly 120-point selloff in AUD/USD, leaving the general unloading of risky assets (like commodities and equities) the culprit of the currencies sharp descent. Turning ahead to the coming week, should the tumble in overbought and risk-related assets continue, the Aussie will likely follow. In the absence of this exogenous risk though, there will be data to fill in the cracks. A general look at the housing sector will kick things off with the AIG’s construction index and government’s building approval numbers. With the benchmark lending rate at an 11-year high, economists are still waiting for housing demand to cool. The following day, the calendar will up the ante with the November retail sales report. With global growth visibly cooling, the need for confirmation of strong domestic demand will increase. And, as for foreign demand, Thursday’s physical trade report will measure exports against Aussie’s insatiable demand for cheaper, foreign goods.

New Zealand Dollar Left to Drift in Its Range
There was little happening in New Zealand markets as traders returned from their holiday vacation. The country’s economic docket was barren; and the lack of fundamental fuel was clearly reflected in the drifting NZD/USD. Since late September, this pair has carved a 500-point wide trend channel with a modest, bullish slope – a sign of the divergence in interest rate expectations. Unlike the US, UK and Canada, expectations surrounding New Zealand monetary policy regime are still pointed skyward. However, it was likely this same sentiment that led to the kiwi’s sharp bouts of selling over this past week. Global interest in risk assets was shaken last week as investors feared the cooling in the US economy was a harbinger of a broader slow down for the rest of the world’s largest nations. Friday’s market panic raised the alert for kiwi bulls. Commodity markets – a prime risk vehicle considering the speculative premium that has pushed many of the more media friendly assets to record highs – entered a steep selloff as the day wore on. However, it was the drop in North American equities which presented the greatest risk for the kiwi’s health on that day and for the future. Stocks dropped sharply through all sessions, but the drop in the US was certainly a degree higher than what the rest of the world benchmarks had seen. This opens the doors to a more extensive correction which could take all other risky assets with it.

Aside from the looming threat of sustained volatility in general risk sentiment, New Zealand dollar traders have little to prepare for in terms of identifiable event risk. The economic docket will trudge through another dull week. The pinnacle of scheduled risk will come with the November trade balance report. Slated for release before active trade even begins for the FX market, the deficit is expected to contract to a six-month low of NZ$465 million. Such a reading would certainly have its influence on more general, fundamental interests – like whether the world is tolerating an expensive New Zealand dollar and the manufacturing sector is weathering high lending rates. And, with few other conflicting indicators from New Zealand (or elsewhere in the world on Monday), a surprise could carry its influence for some time. Ultimately, though, fundamental traders will likely hold the kiwi steady for at least another week. Just around the corner, fourth quarter consumer inflation and business sentiment, retail sales and the RNBZ rate decision will cross the wires to great fanfare.

Boris Schlossberg is a Senior Currency Strategist at FXCM.