Warren Buffet Rescues Bond Insurers and Currencies, But Watch Out for Retail Sales
Warren Buffet’s willingness to take on risk has encouraged other traders to do so as well. According to a plan announced by the world’s most famous investor, Berkshire Hathaway will be stepping in to cover the liabilities of $800 billion in municipal bonds. This vote of confidence has helped to stabilize the stock and currency markets but the lack of a meaningful reaction in US treasuries indicates that Buffet’s investment may not be enough. There are also some strings attached. In order to assume the liability, current insurers would need to pay Berkshire 1.5 times the premium that they are currently receiving. One bond insurer has already rejected the offer and the other two have yet to respond. Focusing on bond insurers will not relieve the credit derivatives market, which has taken the biggest hit in the latest financial crisis. For currencies this means that the rebound in carry trades may be short lived. This weekend, G7 Finance Ministers warned that write-offs on US subprime mortgages could reach $400 billion. Only $120 billion have been announced so far, suggesting that there could be more reasons to sell stocks and high yielding currencies in the weeks and months to come. Carry trades have rebounded today, but don’t expect the recovery to last for long, unless we see some positive US data such as stronger than expected US retail sales. Japan will be reporting their domestic corporate goods price index, current account, trade balance and consumer confidence figures this evening, but we do not expect this data to be particularly market moving because for the Bank of Japan, good news or bad news will not cause them to alter interest rates at their monetary policy meeting on Friday morning.

For Dollar Bulls, Consumer Spending Holds the Key
The US dollar is holding onto its gains as the rate cuts by the Federal Reserve and the fiscal stimulus package announced by the Bush Administration leads traders to believe that the downturn in the US economy will be quick and shallow. Whether or not this is true will be decided by tomorrow’s retail sales report. Consumer spending encompasses 70 percent of the US economy. In the month of December, retail sales dropped for the first time since June. January retail sales figures are expected to drop for the second month in a row by 0.3 percent, which would be the first back to back decline since December 2001. With non-farm payrolls negative last month, chain store sales and consumer confidence declining, it would be surprising if retail sales rebounded. However in the past six years, we have never seen a back to back decline which means that this downturn may be unlike any other. The credit and derivatives driven market turmoil is new and housing has not collapsed like this in decades. As a result, it may be too optimistic to believe that the downturn in the US economy will not last. What we do agree with is the fact that other countries will find themselves behind the curve. When US growth finally stabilizes, many other countries like the Eurozone and Australia may be only at the beginning of dealing with their own slowdown. This scenario is still months away. In the more immediate future, growth is the Federal Reserve’s primary focus. Don’t forget that the futures curve is still pricing in 75bp of easing by June.

British Pound: Vulnerable to Further Weakness
Although the market’s focus tomorrow will be on US retail sales, the British pound will also be in play with employment numbers and the Quarterly Inflation Report due for release. Producer prices grew by the fastest pace in 16 years but the growth of consumer prices fell short of expectations in the month of January. In fact, CPI dropped 0.7 percent, which was the sharpest plunge in a year – though the annual rate edged up to 2.2 percent. What does this mean for the outlook for UK interest rates? It is murkier than ever. For this reason, tomorrow’s reports will be exceptionally important. It will be interesting to see if the Bank of England is still worried about inflationary pressures in their Quarterly Inflation Report. Employment could also weaken, with the labor market components of manufacturing and construction sector PMI declining sharply in the month of January.

Euro: Strongest Rally this Month
Pressure on the ECB to cut interest rates was eased as the ZEW Survey showed a surprising improvement in German Investor Confidence, and led to the biggest gain for the euro this month. Investor confidence beat expectations as it rebounded from a 15-year record low of minus 45 to minus 39.5. The resilience among European investors has stoked further speculation that the ECB will not look to cut rates in the near future as the German Finance Minister Peer Steinbrueck refuted growing speculation that President Jean-Claude Trichet will take a neutral stance on the ECB’s monetary policy. The German Wholesale Price Index and Eurozone’s Industrial Production figures are due for release tomorrow.

Commodity Currencies Fail to Benefit from Yen Rally
Despite the strong rally in the Japanese yen crosses, the Australian and Canadian dollars failed to join the party. Commodity weakened as Australian business confidence deteriorated in the month of January. It seems that the Reserve Bank’s commitment to continue raising interest rates and the slowdown in global growth is cutting into the optimism of Australian companies. We suspect that tomorrow’s Australian consumer confidence numbers will suffer the same fate. New Zealand producer prices also declined last quarter as the growth of both input and output prices decelerated.

Kathy Lien is the Chief Currency Strategist at FXCM.