Strong Consumer Spending Drives Dollar Higher
The US dollar continued to rebound as consumer spending snapped back in the month of January, skirting a repeat of 2001. The market had expected a back to back decline in retail sales, but the last time this happened was 6 years ago. Since then, consumer spending has rebounded every month following a decline and this continued to remain the case in January.
Retail sales increased 0.3 percent last month following a 0.4 percent drop. Excluding autos, sales were also up 0.3 percent thanks to increases in gasoline prices, stronger demand for clothing and health care. However, not all businesses saw an acceleration in spending.  Furniture, electronics, building equipment, sporting goods and department stores all reported sharp declines. The data was positive for the dollar against the Japanese yen, but that was it. The dollar remained unchanged against the rest of the major currencies such as the Euro and British pound. Although the latest consumer spending number helped to alleviate concerns for a recession, retail sales is rising from low levels, which means that the US economy has yet to hit a bottom. Tomorrow the dollar’s momentum may continue with the trade balance due for release. Manufacturing PMI rebounded back into expansionary territory in the month of January which suggests that we may see an improvement in the trade deficit as well. Of course, the US economy is still not out of the woods because the service sector remains vulnerable. Morgan Stanley announced another round of job cuts and analysts are speculating that high mortgage rates will force the Federal Reserve to cut interest rates again. However expectations for another 50bp rate cut has decreased. The market is now only pricing in a 68 percent chance that the Fed will ease by 50 instead of 25, down from 80 percent yesterday.

Euro Recovery Halted by Weaker Industrial Production
After rallying for three days straight, the Euro lost ground against the US dollar on the back of weaker Eurozone industrial production and stronger US retail sales numbers. The market was looking for industrial production to accelerate in the month of December, but a smaller rebound in German industrial production during the same month was the first clue that EZ production could falter as well. A breakdown of the data showed that production of energy and intermediate goods rose by 0.5 and 0.3 percent respectively, but the decline in overall figures were driven by weaknesses in production of capital goods which declined by 1.0 percent. With GDP due for release tomorrow, the latest data confirms that growth will slow in the fourth quarter. However slower growth may not be enough to push the European Central Bank to cut interest rates because inflation still remains a problem. In Germany, wholesale prices increased 1.4 percent last month, bringing the annualized pace of growth to 6.6 percent, the strongest year on year increase in 25 years. ECB President Trichet did not directly address the economy or monetary policy in his speech today, but committee member Liikanen reminded the markets this morning that the central bank is committed to guaranteeing price stability.

British Pound Extends Gains Against the US Dollar
The British pound extended its gains against the US dollar thanks to stronger than expected employment numbers and a mildly hawkish quarterly inflation report. In contrast to the declines in the employment components of manufacturing and service sector PMI, unemployment in January dropped for the 16th month in a row to the lowest level in over 30 years. Despite a slowdown in the housing market and the financial sector, the UK labor market remains strong, offsetting a decline in average earnings growth. The Quarterly Inflation Report was equally bullish for the British pound. Even though BoE Governor King recognized the downside risks to growth, he raised the bank’s inflation forecast and warned that near term inflation will continue to breach their 2 percent goal and runs the risk of breaching the government’s 3 percent limit as well. If inflation rises beyond 3 percent, King would be obligated to write a letter of explanation to Alistair Darling, the Chancellor of the Exchequer and in doing so, it will be difficult for him to justify another rate cut.

Twist of Fate as Canadian Dollar Rallies While Australian and New Zealand Dollars Retrace
The Australian and New Zealand dollars failed to participate in today’s Japanese carry trade rally. This was partly due to Kiwi bearish news and the expectations for tonight’s Australian employment numbers. Starting with New Zealand, Finance Minister Cullen warned that the slowdown in the housing market was sharper than expected. Combined with the recent drought, he projects a slowdown in growth. Home sales, food price and manufacturing PMI were all weaker than expected, adding to the Kiwi’s slide. In Australia, employment numbers are due for release in a few hours. The recent decline in business confidence suggests that the Australian labor market will continue weaken. Meanwhile, the Canadian dollar rebounded despite the lack of economic data. The trade balance is due for release tomorrow and we expect the recent slowdown in US growth to hurt Canadian exports.

Japanese Yen Crosses Extend Gains
The Japanese yen crosses continued to gain ground as the Dow rallied another 178 points. Risk appetite is returning to the markets but we caution traders against becoming overly excited because the strong volatility and global easing will make it difficult for carry trades to return their glory days. Japanese economic data released last night was mixed. CGPI increased more than expected, reflecting strong inflationary pressures, but the trade surplus and consumer confidence deteriorated. Fourth quarter GDP is expected to remain unchanged.

Kathy Lien is the Chief Currency Strategist at FXCM.