Dollar Descends on Dovish Fed
It was a tale of two central banks in the FX market last week as an über-hawkish Jean Claude Trichet was followed by a decidedly dovish Ben Bernanke who stated that the Fed stood “ready to take substantive additional action as needed to support growth and to provide adequate insurance against downside risks.” The news sent EUR/USD rocketing through the 1.4800 figure and it ended the week near the highs. As we noted on Friday, “If ECB remains stationary but the Fed continues to cut aggressively, the inversion in interest differential will weigh on the dollar and the pair could easily retest its all time highs if US monetary policy remains ultra dovish for the rest of this year.”

On Friday, the greenback wasn’t helped by the poor Trade Balance numbers which expanded to -$63.1B against -$59.5B expected. The trade picture deteriorated despite record low exchange rate and puts a serious dent into the bulls arguments that the US economy can overcome the slowdown in housing through growth in exports. With export growth sidelined, consumer is the last bastion of hope for dollar bulls, but given the lackluster Christmas season its doubtful that retail sales would surprise to the upside.

This week the US calendar is quite crowded with reams of key economic data on the docket. The start of the week will see the Advanced Retail Sales numbers, which are expected to be sluggish once again, followed by the TICS data on Wednesday. The TICs report was surprisingly strong last month and should flows prove positive next week, the greenback may see a small boost. Overall however, the economic forecast for data are considerably weak and if they prove to be accurate the dollar is likely to suffer more pain as EUR/USD could possibly challenge all time highs.

Euro – Trichet Warns the Markets
Jean-Claude Trichet presented an ultra hawkish front at the ECB monthly press conference even as he himself admitted that risks in the EZ economy lie to the downside. He stated that the only discussion amongst governing members was between a rate hike or a no-change stance implying that a cut was not even a consideration. While Mr. Trichet’s take-no-prisoners rhetoric is certainly impressive, we continue to argue that unless EZ economic data sees clear signs of improvement the ECB will not hike rates in the first quarter of 2008.

Nevertheless, the markets took Mr. Trichet at his word and the euro rallied hard in the aftermath of the press conference especially after Chairman Bernanke signaled a much more dovish outlook from the Fed. Mr. Trichet continued to emphasize the importance of controlling price pressures and to that end next week’s CPI data is likely to be the most important release from the Eurozone. If core numbers print above the 2.1% forecast expectations for another EZ rate hike before the quarter end are likely to increase irrespective of weakness in consumer demand. However given the lackluster retail sales demand last month and the unexpected drop in wholesales prices, inflation is most likely to remain tame.

The euro continues to trade more as an instrument of anti-dollar sentiment rather than on any intrinsic story of strength. Data last week was essentially negative and next week traders expect few fireworks from the calendar. Nevertheless the path of least resistance for the time being is up as dour US news continues to dominate the landscape.

USD/JPY May Gain Towards 110, But the Move Could Be Short-Lived
The Japanese yen ended last week little changed, despite the fact that risk aversion remained in play and stocks tumbled. Indeed, price action in the USD/JPY pair was based more on movements in the US dollar, as Japanese data has had no impact on the national currency in quite some time. Nevertheless, it is worth looking at what the fundamentals say about the status of the economy , as they will have bearing on the Bank of Japan’s monetary policy decisions in coming months. One of the only pertinent releases from last week was the Eco Watchers survey, which fell to a nearly five year low of 36.6 in December, as sentiment amongst businesses and consumers alike grows more pessimistic by the day. In fact, capital expenditures, wage growth, and retail spending have all softened in recent months, and with commodity prices serving as the only source of inflation in the Japanese economy, it is nearly guaranteed that Bank of Japan Governor Toshihiko Fukui will not have the opportunity to continue on with rate normalization. Moreover, as conditions deteriorate further, the central bank may actually end up cutting rates this year.

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 machine orders are forecasted to plunge while the current account surplus is anticipated to narrow, Nevertheless, risk aversion trends and the status of the US dollar will be the main driver of USD/JPY, and the pair could be in for a bounce in the near term.

UK Data, Rising Libor May Force the BOE to Cut Next Month
While the Bank of England’s decision to leave rates steady, initially gave the British pound a bump higher, as traders had been speculating that they may actually cut rates, the currency eventually continued its descent before finding support. Nevertheless, UK data broadly suggests very dour conditions in the UK economy. Industrial production proved to be weaker than expected in November at -0.1 percent, amidst weak manufacturing, mining, and oil/gas output. The manufacturing sector has already shown some cracks, as PMI pulled back throughout the fourth quarter to 52.9 in December from the August highs of 56.3. While Euro-zone demand for UK exports remains strong, it appears that domestic demand for manufactured goods is weakening, as businesses refrain from investing capital amidst an expected slowdown in global growth in 2008. Likewise, with the UK housing sector quickly deteriorating, consumer spending is anticipated to take a hit as well, and the combination of all these factors does not bode well for GDP reports in coming months.

While the Cable trend is clearly to the downside, there are signs that declines for the pair may be slowing, though a drop below 1.95 would target the March 2007 lows of 1.9186. Such a move may depend more upon whether the markets ramp up their bets that the BOE will opt to cut rates in February, and with Sterling Libor rates picking up once again, the central bank may indeed find it prudent to do so. However, it will be a full month before the BOE meets again, allowing time for Libor to come down, so until then traders will be watching economic data to gauge the chances of another 25bp cut. This week will provide ample opportunities to judge these probabilities, with PPI, CPI, retail sales, and labor market data all scheduled to be released. If inflation pressures prove to be persistent, this may support the case for GBP/USD gains in the near-term, with a push above 1.9675/85 targeting 1.98. On the other hand, retail sales could prove to be disappointing at the end of the week, which could weigh Cable down below 1.95.

Swiss Franc Fights for Gains, Though Risk Trends Look to Pick Up Ahead
Despite a notable lack of scheduled economic event risk last week, the Swiss franc was surprisingly strong. The sole indicator to wade its way into to the market was the monthly employment data for December. Unsurprisingly, the jobless rate last month held at its five-year low 2.6 percent. This was third consecutive month that the series has held this encouraging level; yet fundamental traders seem to be growing less and less impressed by this trend. A strong consumer sector is without doubt a boon for the Swiss economy; but it has become an anticipated one. With global activity beginning to cool and after the Swiss National Bank decided to leave the nation’s benchmark lending rate unchanged in December, traders are now more concerned with the indicators that are known to offer an advance reading on growth and inflation trends. This need for leading data likely places a fundamental premium on the SVME PMI figure, which gauges the health of the business sector and therefore provides a leading view on the demand for labor.

It was outside of the clean cut world of scheduled event risk that the Swiss franc was really finding its paces last week. The carry trade appeal of the low yielding swissie was clearly holding sway over price action for most of the week. The week begin innocuously enough with most of the more popular risk-related assets holding tight ranges. The mood soured for investors on Tuesday though after Countrywide, one of the US’s largest mortgage firms, marked its biggest one day loss since Black Monday back in October of 1987 on rumors that it was heading for bankruptcy. If this once financial service staple went under, the conditions for credit market would no doubt be considered worse than most analysts had initially though – not to mention it would signal that the subprime mortgage mess was torpedoing large and supposedly financially stable companies. By the end of the week, the concern surrounding this media target was wiped clean when Bank of American announced its plans to purchase the troubled firm. However, despite this reassurance, the carry trade marked its biggest unwinding and US equities plunged nearly 2 percent on Friday. Attention shifted from this merger to expected profit announcements next week where a number of firms are expected to release reduced fourth quarter profit and put risk appetite back on the run.

In the days ahead, the swissie’s fate will most likely be tied to the ebb and flow of risk appetite and risk aversion. The carry trade will likely be highly sensitive to a few key earnings reports scheduled throughout the week. Citigroup and Merrill Lynch are each expected to report additional $15 billion writeoffs in mortage-related losses. Should the substantial mark downs of from the previous quarter be revisited, it would not be out of the question to see the same level of volatility as that period. As for economic calendar, only one notable indicator is scheduled for release. There is no official consensus for the ZEW investment and analyst sentiment survey, but given the 18 consecutive months without a positive reading and the deceleration in Euro-Zone growth, the outlook isn’t good.

Canadian Employment Boom Stalls, the Loonie Has a Long Way to Fall
The top market moving currency last week was without doubt the Canadian dollar. Though USD/CAD didn’t see the largest percentage change among the majors (deferring that title to AUD/USD and NZD/USD), its sharp, end of the week move and the dramatic shift in fundamentals certainly won it a place of honor among volatility traders. The pair began the week with its usual chop as the first few trading days didn’t see any economic indicators, commodity markets had stalled in their respective advances and the greenback was treading water. All that changed on Wednesday though. In the past few weeks, forecasts for strong Canadian growth had already taken a serious blow when the physical trade balance contracted to its smallest positive balance since 1998 and the Ivey PMI survey reported its worst reading for business activity in six years. However, both of these shifts were more or less expected given the unfavorable exchange rates and waning demand from the US. The sharp drop in housing activity reported on Wednesday was not. According to government statistics, housing starts over the month of December plunged to an 187,500 annual pace – the lowest reading since April of 2002. Despite this shocking statistic though, the data was salvageable for Canadian dollar bulls as activity for the entire year was actually the strongest it's been in 20 years. The rest of the housing data released the follow day was less dramatic, but still held a bearish tone. However, certainly concerning was the cooling in the annual reading of the New Housing Price Index for November to a 6.1 percent clip – extending a steady deceleration.

The real fireworks for last week were reserved for Friday. In the past few months, the Canadian employment report has been more market moving than the hailed US NFPs. Crossing the wires free from interference from the US payrolls report for the first time in months, the Canadian labor survey revealed the first drop in net employment in 8 months. This print was a blow to the long-term fundamental and event risk traders alike. For the latter, they were used to seeing the change marking a positive surprise that was at least three times the official forecast. And, for the fundamental traders, with their eyes on growth and the BoC, the tangible change for the consumer sector suggested all the largest sectors contributing to the Canadian economy’s impressive rise were now threatening its untimely decline. However, bullish conviction have not been fully snuffed out as we still require confirmation of a true change in labor trends, especially after wage growth accelerated to its fastest clip on record.

In the coming days, the economic train will certainly be throttled back. The first indicator of note is Thursday’s international securities transactions. Unlike the physical trade report, this indicator will struggle to command the attention of the trading masses. The same is true about the manufacturing shipments report for November – though a large shift could revive concerns over trade health. Regardless, technical traders will likely monitor the strength of 1.0250 to judge whether the USD/CAD is already forming a new bull wave.

Aussie Shows Few Signs of Slowing, But Much Depends on Labor Data
The Australian dollar joined other major world currencies and rallied significantly against its US namesake, with impressive Retail Sales and Building Approvals data serving to further boost the Aussie against other global counterparts. Extreme British Pound weakness forced the GBP/AUD to its lowest levels in 10 years, but the Aussie dollar nonetheless underperformed against New Zealand’s buck, leaving the AUD/NZD almost exactly unchanged. A broad sell-off in high-yielding currencies and risky asset classes was not nearly enough to contain the AUD/USD, however, as the Australian currency received a key fundamental boost from domestic Trade Balance, Retail Sales, and Building Approvals figures. The country’s trade deficit fell from a record A$2.86 billion in October to a better-than-forecast A$2.25 billion through the month of November. A surge in exports completely offset a smaller gain in imports, and the report generally improved outlook for Australia’s international balance of payments. In other similarly positive news, Building Approvals surged an impressive 8.9 percent in November—significantly better than economists’ forecasts for no change. A one-off 28.4 percent gain in Apartment approvals led the figure higher, but the report was otherwise generally upbeat and spoke well of housing prospects for the Asia-Pacific economy. Such housing market strength unsurprisingly coincided with robust Retail Sales results on the month, and outlook remains positive for domestic consumption trends.

Given consistently strong economic data, it seems as though the Australian Dollar may continue higher through the medium term. That said, economic outlook could potentially take a turn on key Employment Change figures due January 17 at 00:30 GMT. Markets greatly anticipate the key year-end labor report, as most are keen to watch whether or not the domestic jobs market continued its impressive growth through year-end 2007. Current consensus forecasts of a 20.0k are certainly on the optimistic side, but Aussie employers have shown little moderation in appetite for new workers. Such dynamics were easily seen through November when the economy added an incredible 52,600 new jobs. Adjusted for labor force participation, this would roughly correspond to a 700,000 jobs gain in the monthly US Non Farm Payrolls report. This is obviously a gross oversimplification, but it remains clear that Aussie labor market strength has been nothing short of impressive. Whether or not this can continue through the new year may determine outlook for consumption and housing trends, with Aussie traders to closely watch for any surprises from the highly anticipated report.

New Zealand Dollar Left to Drift in Its Range
The New Zealand dollar shrugged off disappointing Trade Balance figures to finish significantly stronger against the greenback to finish the week’s currency trading. The Kiwi saw its strongest rallies against the US dollar on commentary from US Federal Reserve Chairman Ben Bernanke in which he quite plainly said that the central bank stands ready to cut rates “substantively” in the face of domestic economic slowdown. Such frank words easily allowed forex markets to pound the already-downtrodden USD, while a simultaneous rally in global risky asset classes provided a double-boost for the NZD/USD currency pair. A recent improvement in investor risk sentiment certainly bodes well for the Kiwi, and a solid NZD/JPY rally proved the point. Yet it remains to be seen whether the high-yielder can hold its ground on yields alone, especially as it sees strong competition from the similarly high-yielding Australian dollar. The Kiwi could see major declines against the euro, with a topside breakout in the EUR/NZD a distinct possibility through upcoming trade.

Whether or not the Kiwi continues its recent run may very much depend on upcoming Consumer Price Index figures on January 16, with Reserve Bank of New Zealand interest rate expectations hanging very much in the balance. According to some forecasts, year-over-year CPI inflation will break above the RBNZ’s 1-3 percent target range at 3.1 percent. Such a result could easily alter forecasts for domestic yields, and an above-consensus result could only bolster the case for higher New Zealand interest rates through 2008. The Kiwi already enjoys the highest official interest rate of any currency with the highest S&P Sovereign debt rating, and any rises in the record 8.25 percent rate could only further boost yield-linked demand for the NZD. That said, it will nonetheless be very important to watch the performance of global risky asset classes. Given that the high-yielding currency performs best in times of relatively low market volatility and equity market gains, it will be critical to monitor any unexpected tumbles in the Dow Jones Industrial Average or top Asian and European indices. Otherwise, Kiwi traders will watch Thursday’s Retail Sales report to gauge overall consumption strength in the small Asia-Pacific economy.

Boris Schlossberg is a Senior Currency Strategist at FXCM.