Dollar – Data Doesn’t Matter
It was a sea of red ink on the US economic calendar this week as Factory Orders, Pending Home Sales, ISM Non-Manufacturing and jobless claims all printed much worse than expected, practically assuring a Fed rate cut at the next meeting in March. The dollar however couldn’t have cared less. The unit gained 300 points in an near vertical fashion as market sentiment changed completely from focusing on US economic woes to worrying about slowdown in the rest of the world.

As we wrote in our special report, Why is the Dollar So Strong? “While the data continues to point to further EUR/USD strength, the price refuses to confirm this analysis and as traders we should respect the message that price is sending.” That having been said, the EUR/USD appears to be finding a modicum of support at the 1.4500 level.

As we noted on Friday, “If the EZ economy is able to weather the slowdown in global demand without seeing any material deterioration in its labor markets, the ECB may keep rates at 4% for much longer than the market thinks. The Fed in the meantime will continue to lower the Fed funds rate perhaps to 2% by the middle of this year. Yesterday’s weekly jobless claims which printed above the key 350k barrier suggest that the labor situation in the US is rapidly becoming worse. The market therefore may be underestimating the length and the duration of interest rate advantage that the euro may have and once traders appreciate that possibility the EURUSD should resume its upward trek.”

Next week the data could play a much more critical role as traders will get a look at Retail Sales, Trade Balance and TICS. Of the three, the TICS release could be the most market moving. Up to now the greenback been well protected from capital flow concerns as TICS have generally printed well in excess of $60 Billion. If however, the data shows a serious drop-off in flows, the dollar may resume its slide.

Euro – Trichet Senses Trouble
As we wrote on Friday, “ECB chief Jean Claude Trichet tried to valiantly adhere to his hawkish bias during yesterday’s post announcement press conference, but the market refused to believe him in light of the latest economic data from the region that has shown very steep declines in service sector activity.” This was the week when the de-coupling argument came under full assault. For the first time this year, the market saw credible evidence that the EZ economy may not immune to a US slowdown. The PMI service report which slipped to within a whisker of the 50 boom/bust level and more importantly the German component which did drop below 50, all pointed towards trouble on the horizon for the region’s economy.

The key, in our opinion is the state of the labor market. If the deceleration in US growth creates similar woes across the Atlantic, causing a spike in EZ unemployment figures the political fallout from high euro and relatively high interest rates is likely to put enormous pressure on the ECB to begin lowering rates thus eliminating much of euro’s interest rate advantage. This week’s 300 point decline in the EUR/USD is in effect a bet by dollar bulls that this scenario will soon develop.

Next week, the EZ economic calendar will provide the market with more solid clues as to the true state of affairs in the 15 member union. The German ZEW survey and more importantly the EZ GDP numbers will be a good measure of negative impact of the US slowdown. The GDP data is expected to print at 0.4% vs. 0.8% as market already expects much more lethargic growth. If however, the data prints to the upside some of the major concerns swirling about the euro may begin to fade away.

Yields Drive Dollar-Yen
After barely breaking the 105.00 barrier two weeks ago USD/JPY staged a massive reversal on Thursday jumping nearly 2 big figures as US long term yields shot up in the wake of a very disappointing 30 year bond auction which saw only a modest 1.82 bid to cover ratio. The yen was then further damaged by disappointing data out of Japan on Friday which saw the Eco Watcher survey slide to 6-year low.

The Eco Watchers survey, which is a poll of barbers, taxi drivers and waiters, is one of our favorite gauges of economic sentiment in Japan and the fact that it is plumbing the lows at the moment confirms our thesis that the high value of the yen is beginning to have a significantly negative impact on Japanese economy. As we noted, “In 2008 Japanese multi-nationals may be squeezed from both sides as the high value of the yen and the global economic slowdown could prove to be a deadly combination as it raises costs while limiting sales. Already in the month January Toyota, Honda and Nissan experienced year over year declines in sales of as much 7% as the industry steels itself for its worst year since 1998.”

Next week the Japanese calendar provides some key event risk for traders to consider. On Tuesday Domestic CGPI is expected to decline to 0.0% from 0.4% the month prior, fueling fresh speculation that country may be dipping back to deflation. On Wednesday the GDP data is expected to show a small level of improvement, but given the softness of the recent reports and downside surprise is likely. And finally Thursdays BOJ meeting is expected to provide little fresh news with rates remaining unchanged since February 2007. USD/JPY however remains vulnerable to risk aversion sell-offs and if equities once again swoon next week, the critical 105 level may come into play.

Will Inflation Concerns Lead the British Pound to Rebound?
While the British pound started out last week on a strong note, traders eventually went back to pricing in the expected 25bp rate cut by the Bank of England. Indeed, GBP/USD fell further as the bank’s policy statement cited deteriorating prospects for global output growth and tightening credit conditions for consumers and businesses alike. While the Monetary Policy Committee did say that rocketing energy and food prices are “expected to raise inflation, possibly quite sharply,” the subsequent cooling effect on demand growth is anticipated to be enough to “return inflation to target in the medium term.” Essentially, the Bank of England is more concerned that slowing growth will bring inflation below target than they are concerned that inflation will accelerate out of control, suggesting that more rate cuts may loom on the horizon as long as economic data points to deteriorating conditions.

Last week’s data releases underpinned the bank’s statement, as industrial production unexpectedly declined amidst a reduction in orders for metal products and textiles. The construction purchasing mangers index weakened to its lowest level since September 2006, and is expected to continue to decline as the UK’s decade long housing boom has ended. Although, services PMI came in stronger than expected, the new business and business expectations components came in lower, showing clear signs of an economic slowdown.

Looking at this week’s economic docket, we see that if there is any validity to the BoE’s inflationary concerns, it will be spelled out this week when the bank releases its Quarterly Inflation Report. The supporting fundamental data is expected to support their claim as producer input prices are expected to increase on a monthly basis and 14.3% year over year- which would be the highest since April 2006. CPI is also expected to increase 2.3% on a yearly basis, its highest level in six months and further away from the BoE’s 2% tolerance level. Traders will closely watch the inflation story as it unfolds, looking for signs that it may move to the front of the BoE’s priority list. If they feel that this is the case then they will expect the BoE to take a more measured approach to future rate cuts, which may be to the benefit of the GBP/USD pair. However, any signs of easing will give investors the confidence that the BoE will quicken the pace on future rate cuts and send the pound down toward yearly lows.

Swiss CPI Breaches SNB’s Inflation Ceiling – Will They Hike?
The Swiss franc lost its luster last week as the US dollar posted a solid rally across the majors. Nevertheless, data out of Switzerland reflects the picture of a robust and resilient economy. Labor markets remained tight in January as the unemployment rate held steady at a seasonally adjusted 2.6 percent. Meanwhile, the unemployment level fell to 99,752 - the lowest in over five years - as businesses take on workers and boost output in order to meet strong demand. Indeed, the January SVME Purchasing Managers Index unexpectedly improved to a reading of 61.6 from 60.8, with nearly every component (including output, purchases, and prices) rising. Ironically, the one component to slip was employment, but nevertheless, it appears that export and domestic demand should be able to keep Swiss expansion humming at a relatively solid pace in early 2008.

Meanwhile, though Swiss CPI eased back 0.3 percent during the month of January, the annual rate unexpectedly climbed to 2.4 percent, which is the highest in more than 14 years and marks the first time in more than 12 years that CPI has breached the Swiss National Bank's 2.0 percent tolerance level. The acceleration came as crude oil hit a record of $100.09/bbl on January 3, while food prices rocketed higher as well. The question is: will it lead the SNB to consider hiking rates from 2.75 percent? Unlikely. Indeed, the European Central Bank is grappling with a similar problem, but with the downside risks to growth looming so large, a rate hike by either central bank would likely prove to be purely detrimental to the economy.

Looking ahead to this week, with little in the way of Swiss data scheduled to be released, USD/CHF will likely remain driven by the US dollar and risk aversion trends. Like the Japanese yen, the Swiss franc tends to benefit from flight-to-safety, and typically loses out when the markets are willing to take on more risk. While immediate resistance looms at 1.1050/57, a bout of greenback strength could send USD/CHF higher next week to target 1.1160.

Canadian Dollar Rebounds as Data Signals Economic Resilience
The USD/CAD pair didn’t manage to stray far from parity last week, as Canadian stronger-than-expected economic data prevented Loonie bulls from straying. In fact, the Ivey Purchasing Managers Index surprisingly rose above the crucial 50 contraction/expansion mark, registering at an impressive 56.2 through the month of December and easing fears of a sizeable slowdown in domestic industrial production. Indeed, given recently dismal US ISM Manufacturing and Non-Manufacturing reports, many feared that Canadian industry would experience much the same slowdown as its southern neighbor. Yet this report easily dispelled much of those fears, and in terms of the underlying components, noteworthy improvements were seen across the board. The Employment sub-index rose into expansionary territory with a 4.8 point jump to 52.8, and was proven to be a excellent signal for Canadian labor market reports at the end of the week. Employment figures bounced back in a big way in January, with the net employment change surging a greater-than-expected 46,400 after tumbling 18,700 in December. Meanwhile, the unemployment rate surprisingly fell to a 33-year low of 5.8 percent. It appears that despite a sharp slowdown in business and trade activity at the end of 2007, conditions improved in early 2008 as domestic demand remains robust. Furthermore, the news indicates that the Canadian economy may be better equipped than previously expected to weather a massive slowdown – or worse, a recession – in the US.

That sentiment may fade this week as new housing prices, the trade balance, and manufacturing shipments are all forecasted to soften. However, as Technical Strategist Jamie Saettele points out in Friday’s Daily Technical Report, the risks for the USD/CAD pair loom to the downside. Furthermore, given the US Dollar’s sharp rally last week, the currency may be prone to declines and this may work in the Canadian dollar’s favor this week.

Aussie Sells on the News
While the rest of the world is thinking of easing, the RBA remains unrepentantly hawkish raising rates another 25bp to 7.00% last week. In a typical buy-the-rumor-sell-the-news fashion however, the Aussie - which ran all the way to the 9000 figure the week prior - spent last week mostly selling off. The weakness in the unit was amplified by fears that the RBA may have miscalculated, tightening credit conditions just as global economic slowdown would dampen demand from the country’s biggest customer – China.

Australia has been the primary beneficiary of China’s nearly insatiable demand for resources which has spurred massive labor demand from the country’s mining producers pushing wages and prices higher. Last week’s Retail Sales figures, although slightly missing their target still rose at a healthy 0.5% rate indicating that the economy Down Under continues to boom and for the time being RBA’s hawkishness may be warranted. If the global slowdown is indeed relatively mild then the Aussie stands to benefit tremendously as its 7.00% yield will attract massive amounts if capital if risk assumption returns to the market.

Next week, the Australian calendar is considerably more subdued with only the employment data worthy of note. The market is looking for a mild decline to 15K from 20K the month before, but with the ultra low unemployment rate of 4.3% Australia remains one of the most dynamic economies in G-10. If equities show strength next week and carry trades revive, the Aussie could make a fresh assault on the 9000 figure after consolidating this week.

New Zealand Dollar Recovers on Powerful Unemployment Report
The New Zealand dollar finished the week only marginally lower against its US namesake, as impressive Kiwi economic data offset similarly noteworthy greenback strength. If we look past the US dollar and a similarly buoyant Canadian currency, however, the NZD outperformed all other G10 counterparts on the strength of domestic employment numbers. Thursday’s labor market report showed that the level of employment in the New Zealand economy surged 1.1 percent through the final quarter of 2007—a whopping 0.8 percentage points better than the median analyst forecast. Combined with a bullish Wages result and a noteworthy drop in the unemployment rate, the employment data was unquestionably bullish for New Zealand’s economic prospects. Such a shift in sentiment forced a substantial NZD rebound, and we likewise saw an important shift in Reserve Bank of New Zealand interest rate differentials. The spread between the New Zealand Dollar 3-month Swap Rate and 1-year rate turned positive after the impressive economic data—signaling that markets may believe that interest rates will remain unchanged through the medium term. In fact, some analysts now predict that the RBNZ will be forced to raise rates beyond current record-highs of 8.25 percent to offset a tight labor market and buoyant commodity prices. These developments are undoubtedly bullish for the Kiwi, which may look to challenge new heights against key forex counterparts.

Traders await the coming week of economic data for better guidance on the future of RBNZ rates, and any disappointments in Producer Price inflation figures or Retail Sales results could potentially temper Kiwi gains. PPI numbers will be important as a confirmation to earlier CPI and Wage Prices data results, as the domestic central bank is virtually certain to take all measures of inflation into account in subsequent rate decisions. The following Thursday’s Retail Sales report may likewise prove significant in the interest rate debate, and any surprises could easily force major Kiwi volatility. Markets have now priced in stable interest rates through the year ahead, any shifts in this sentiment would remove a key pillar of support from the recent NZD upswing. It will likewise be important for traders to watch global risky asset classes—especially the US Dow Jones Industrial Average and the Japanese Nikkei 225 Index. As always, the Kiwi will prove highly sensitive to any shifts in risk sentiment across global financial markets.

Boris Schlossberg is a Senior Currency Strategist at FXCM.