Dollar – Bernanke Breaks the Buck
So much for the dollar rally. On Thursday Chairman Ben Bernanke delivered another pessimistic forecast to Congress, leaving little doubt that the Fed will continue to lower rates, most likely by another 50bp at the next meeting in March. The net result was a wave of dollar selling as interest rate differential dynamics came right back into play. Friday the news only got worse as U of M Consumer Confidence survey hit a 16-year low and Empire Manufacturing dropped like a stone from 6.5 expected, to print at –11.7.

However, perhaps the most important release last week was the miss in the TICS data which printed at 56.5 versus 73.5 expected. The capital flows were substantial enough to offset the shrinking Trade deficit, but the data was for December and it will be interesting to see if capital flows begin to contract in the wake of January’s turbulence in the equity markets. As we’ve noted many times before, the financing of the US Trade deficits has been a non-story for many years as capital flows have been more than sufficient. However, if the mismatch between TICS and Trade deficit becomes persistent, the whole focus of currency trading will shift from concerns about economic growth to worries about structural viability of the US economy.

Next week the calendar is relatively tame with only the CPI data providing any meaningful guidance to traders. Market is looking for a slightly hotter number of 4.2% vs. 4.1% but a strong possibility exists that the data can surprise to the upside given the escalating costs in energy and food. This will of course put the Fed into a bigger bind as they will have the unpleasant choice of either curtailing inflation or stimulating growth. As this point the US monetary policymakers have clearly decided that growth matter more, leading to further rate cuts and dollar declines in the near term.

Euro – Support in Place But PMI Holds the Key
A bounce in the ZEW,a bit better than expected GDP read and a stream of negative surprises out of US and suddenly the euro is back in the race. After having found support below the 1.4500 level, the EUR/USD climbed steadily for the rest of the week breaking through the 1.4700 figure before running out of stream. However, as we noted on Thursday, “The rise in the euro … was restrained by the lackluster GDP data which printed at 0.4% in Q4. Although the news met consensus expectations, in absolute terms it marked a 50% decline from the growth levels in Q3 and indicated that growth in 2008 is likely to slow 1.7% from 2.3% in the year past. Given this deceleration analysts have suggested that ECB could begin preparing the market for possible easing as early as Q2 of 2008 and those concerns limited the gains in the unit.”

The fear of a possible turn in ECB monetary policy kept euro bulls at bay, as worries persisted that the unit’s interest rate advantage over the dollar will only be temporary. The key to ECB’s continued hawkish posture will be the strength of the region’ manufacturing sector. Despite the deficit reading in the latest EZ Trade Balance data, we noted on Friday, “A closer look at the figures revealed that the gap was due primarily to energy and crude material costs while manufactured goods actually increased from 222 Billion euros to 249 Billion euros. Nevertheless, tonight’s deteriorating trade figures from Europe stand in contrast to yesterday’s better-than-forecast trade numbers from the US and suggest that despite the Herculean efforts by European producers, the unfavorable exchange rate is starting to exert a toll. “

Just how big that toll be will be seen next week, when traders get a look the PMI Manufacturing and Services indices. For the EUR/USD bull case to remain intact, both gauges must stay above the 50 boom/bust level. With PMI Services within a whisker of slipping below that barrier, the unit could see some pressure if data shows that economic activity is now contracting. The EUR/USD appears like it wants to make another run at the highs, but it will have much harder time doing so if data is not supportive.

Yen Back to Risk
As expected the BOJ left interest rates on hold at 0.5%, and as we noted on Friday, “The only slight surprise from the BOJ meeting was the relatively hawkish posture of Governor Fukui. Many analysts expected the BOJ chief to perhaps signal the start of a new easing campaign in light of the fact that Japanese consumer confidence surveys have hit 6-year lows. But Mr. Fukui noted that the positive cycle in Japan economy while weakening but still intact, essentially quelling any notion of easing in the near term. USD/JPY initially rallied as carry demand drove the market but then turned and dropped through the 108.00 level as traders reconsidered the implication of Governor Fukui’s words.”

The yen trade continue to revolve around risk appetite/risk aversion dynamics. Risk appetite actually increased last week as equity indices rallied in the wake of Warren Buffets offer to the monoline insurers and better than expected US Retail Sales data. However, the situation in the credit markets remains tenuous at best and should stocks begin to swoon again this week, yen could strengthen once again.

The Japanese calendar next week carries only minimal event risk with Tertiary Industry Index expected to contract, but the All Industry gauge forecast to rebound. Japanese economy continues to be extremely sensitive to global demand and rate policy will remain dormant until BOJ sees concrete signs of improvement. Ironically enough, negative news on the global economic front will likely lead to a strengthening of yen while positive news will drive yen lower as carry trades dominate flows. Therefore, the 105 level remains critical for yen traders to observe.

BoE Inflation Report Hawkish, Yet Pound Outlook Remains Mixed
The pound was marching higher through most of last week, as fundamental traders waded through a series of bullish top-market-moving indicators with bearish footnotes. The market hit the ground running on Monday when the government released its gauge of factory-level inflation. The PPI has been a point of bullish interest for some months, and the January reading was no exception. Steadily rising raw material costs pushed input price pressures to its fastest pace of inflation in 28 years. However, the real market impact came from the output gauge which accelerated to a 16-year high as producers throttled back on discounts. Perhaps its was in reference to these incredible numbers that the MPC forecast frontline inflation holding above its 2 percent target for the next two years, and that pressures could top 3 percent before then. Such rhetoric was very hawkish considering the BoE has cut rates twice – once in December and again earlier this month. Certainly, current consumer-level inflation readings aren’t showing such pressures. January CPI printed a modest 2.2 percent headline pace and a 17-month low 1.3 percent core figure.

And, where the inflation considerations for monetary policy leave off, the growth aspect picks the argument back up. Trade remains a weak point for the economy. Though the visible balance has improved for three consecutive months, it still very close to a record deficit. What’s more, the BRC’s leading indicator of retail sales for January casts doubt on the health of the vital consumer sector. Though the spending gauge rose to a four month high, the increase was mainly seen in food (a necessary good heavily influenced by higher prices) while clothing sales fell. On the other hand, the ever reliable employment report remains in the bulls corner. Jobless claims fell for an unprecedented 16th consecutive month, bringing the indicator to its lowest level since 1975. So a dovish outlook on consumer spending will need to come from other sources.

Over the coming week, the economic calendar has certainly lost steam after shedding so many top market moving indicators. Nonetheless, there are a number of scheduled indicators that could have their way with price action as sleeper, second tier numbers. The leading Rightmove housing prices indicator will gauge the health of quickly sinking residential market. A fourth consecutive drop in prices would be the longest record on records going back to 2001 and would undoubtedly rouse comparisons to the US housing recession. The BoE minutes will have little impact on the market since the recent quarterly inflation report has already offered the bank’s outlook. For the rest of the week, the focus is on the consumer. The finance numbers will report on the fragile credit situation. Finally, January retail sales will be an unbiased indication of consumers’ outlook on the economy and their financial position.

Swiss Lead Higher on Risk Aversion, Data Comes into View
The Swiss franc was under the control of risk appetite through much of the past week. Chop in the first half of the period matched the lack of direction from global equities over the same period. Then, holding true to its risk roots, when the market was drawn into a bullish run that began in the benchmark stock indices and spread to the yen crosses, the Swiss franc was quick to follow with a sell off of its own. What’s more, a few exogenous news events had contributed specifically to the down turn in the swissie. Growth numbers from the Euro Zone weighed on forecasts for Swiss exports over the coming months. Expansion across the Euro Zone (Switzerland’s largest trade partner) cooled to a 2.3 percent annual pace in its advanced fourth quarter reading – the weakest pace of expansion in two years thanks to a cooling in consumer demand. Further adding to the franc’s weight, ECB president Trichet marked rouse dovish suspicions for one of the few remaining hawkish central banks when he suggested the cooling in European growth would be more significant than he originally thought.

Looking back within the Swiss boarders last week, there was very little direct influence from the economic docket. Only the ZEW survey for the month of February was crossing the wires. And, unlike German investor and analyst sentiment which improved over the month, confidence in Switzerland plunged to a new record low as respondents feared the slowdown in the US would lead a cooling in global growth. Investors who expect the economy to worsen over the coming six months jumped from 19 to 56 percent according to the report. This rise in pessimism comes just after UBS reported a $14 billion write-down on mortgage-backed securities and an $11.3 billion loss for the fourth quarter – the largest recorded by a bank in history.

Looking out over the coming week, the domestic economic winds will pick up once again. The Swiss December retail sales report is one of few indicators scheduled for release across an otherwise barren day. Domestic spending is expected to support the economy for another month with economists forecasting a 5.2 percent increase in sales activity. Such an improvement would not be shocking as this indicator is rather volatile; but with UBS’s consumption indicator cooling over the same period, a pick up in sales would improve the swissie bull’s outlook. The second round of data comes on Thursday’s trade report and upstream inflation reading. The physical trade balance is expected to have rebounded through January after correcting a multi-year high set in November. The inflation report could help to stoke interest in price pressures and its potential influence on the SNB’s March rate decision. After CPI hit a 14-year high, an increase in inflation in the pipeline could carry hawkish expectations into the central bank’s next policy decision.

Canadian Dollar Sees End of Week Selloff as Data Falters
There are few bright spots left in Canada to suggest the world’s eighth largest economy can survive the United State’s dramatic cooling unscathed. Not one of the upper echelon Canadian indicators that crossed the wires last week had actually supported a booming economy for the coming months. The disappointment began early as the new house prices indicator for December cooled more quickly than economists had expected to match its weakest monthly increase in a year. This bodes poorly not only for the housing market, but also the health of consumer spending and overall inflation. From housing, the market moved on to the Canadian dollar’s influence on manufacturing and trade. Manufacturing shipments through the end of the year dropped 3.4 percent, the biggest slump in over four years. However, bulls could have hung on to hope through this report as this reading was heavily influenced by the auto sector which reported its biggest plunge in shipments since 1996. On the other hand, there was little such lingering optimism in the international merchandise trade report for the same month. The smallest surplus in nine years stands as a clear evidence to fundamental traders that the stubbornly high currency and the developing slowdown in the US (which consumes 80 percent of Canada’s exports) would not allow Canada to escape the global cooling.

While these individual data points had built bearish fundamental pressure behind the pound through the week, the biggest move in price action came on the basis of a purely technical move rather than on the economic calendar’s concise schedule. Friday saw the greatest volatility for the loonie all week. While the currency fell against all the most actively traded pairs, the USD/CAD made the most remarkable move in a rally 200-point turnaround. The technical setup for USD/CAD is one of the most interesting among the majors. For the past month, the pair has cut a very concise range between 1.0120 and 0.9925. What’s more, this congestion is forming right into the floor of a notable, rising trend channel. Such technical pressure could line up this week’s fundamental releases for a remarkable breakout.

Looking over the economic offerings over this week, we could ask for any more market moving indicators from the Canadian coffers to have a go at the USD/CAD range. In fact, the Canadian calendar has the greatest potential of all the majors’ dockets. Tuesday’s consumer inflation report will be the first top tier number to have a crack at driving the Canadian dollar. Headline inflation is expected to pull back even further from its 19-year high set in November. Perhaps more remarkable could be the core reading which is expected to decelerate to its weakest pace in two and half years. Such a reading wouldn’t almost certainly lead traders to price in a March 4 rate cut. If the CPI number fails to force a break, the retail sales gauge could certainly do it. Though only a modest change is expected, this report is a consistent driver.

Australian Dollar Rises Sharply on RBA Rate Hike Expectations
The Australian dollar moved to fresh multi-month highs on the trading week, as a significant boost to domestic interest rate expectations increased the attractiveness of the high-yielding currency. The highly-anticipated Reserve Bank of Australia Quarterly Monetary Policy statement underlined the central bank’s fear of rising price pressures in the domestic economy, with aggressively high inflation forecasts suggesting that the RBA stands to raise rates at its subsequent policy meeting. Prior to the release of official RBA statements and forecasts, analysts and traders overwhelmingly predicted that the Reserve Bank would leave its cash target unchanged at its upcoming March meeting. Yet the distinctly hawkish tone has clearly caused a shift in expectations, and now we see that 23 of 24 analysts polled by Bloomberg News expect the RBA to raise rates by 25 basis points at its March 3 announcement. Such a dramatic shift clearly underlines changing sentiment for the AUD, and it is subsequently unsurprising to see that it rallied strongly against lower-yielding counterparts on the news.

Barring any unforeseen circumstances, we would argue that risks remain to the upside for the Australian dollar on solidly anchored interest rate expectations. Unlike the majority of prominent central banks, the Australian monetary policy authority stands ready to increase rates despite clear signs of global economic slowdown. Such dynamics leave it in stark contrasts to the US Federal Reserve, Bank of Canada, and Bank of England, who have already lowered interest rates in fear of a slowdown in economic activity. Some analysts argue that it may be only a matter of time before the Reserve Bank of Australia moderates its tone on price pressures, but powerful global commodity prices and robust demand for Australian production from China could easily keep Aussie industry afloat through the medium term. Of course, a crash in commodity markets would easily undermine a key source of Australian dollar support, but it will be difficult to predict when and if that may occur.

The upcoming week of Australian economic event risk is comparatively limited, but markets may post strong reactions to any surprises out of Wage Cost Index figures due on the 19th. Given high inflation expectations, economists believe that Wage costs rose by a robust 1.1 percent quarterly rate through the end of 2007. Any surprises to the downside could easily force a pullback in the high-flying Australian dollar, while rallies on a strong release are somewhat less likely. Otherwise, traders should watch for any significant shifts in global risk sentiment.

New Zealand Dollar Recovers on Powerful Unemployment Report
The New Zealand dollar was one of the few currencies to stay flat against the US dollar on the week, as mixed domestic economic data and a drop in the Dow Jones Industrials Average limited the attractiveness of the Asia-Pacific currency. In fact, the Kiwi was the second-worst performer among all G10 currencies through the six-day trading period. Recent New Zealand economic data showed that the domestic real estate market continues its fairly sharp recession; REINZ House Sales fell a substantial 31.5 percent on a year-over-year basis. All the while, recent Producer Prices indices printed above consensus forecasts and underlined rising inflationary pressures for the domestic economy. The mixture of high price pressures and signs of slowing economic activity leaves the New Zealand economy in a difficult position. On the one hand, rising inflation may warrant further interest rate increases from the Reserve Bank of New Zealand. On the other we see that economic growth risks remain to the downside for New Zealand—leaving the central bank to take a more moderate stance on future monetary policy. Currency traders’ ambivalence towards the Kiwi subsequently underline the countervailing forces on the domestic currency, and it is difficult to establish a firm fundamental bias for the NZD.

The week ahead will bring relatively little in the way of relevant economic data, with Performance of Services and Credit Card Spending data unlikely to force major shifts in New Zealand economic sentiment. Instead, we will likely see the New Zealand dollar trade off of changes in global risk sentiment, especially as it relates to major US and Japanese equity indices. The correlation between the Kiwi and these key risky asset classes has weakened through recent trade, but we will likely see the Kiwi react to any major moves in the US Dow Jones Industrials or the Japanese Nikkei 225. Given a heavy concentration of US economic event risk on February 20, New Zealand Dollar traders should watch for any particularly noteworthy reactions from US equity markets.

Boris Schlossberg is a Senior Currency Strategist at FXCM.