What to Expect for the US Dollar
The dollar has weakened this past week, but the question on everyone’s mind is how bad is the US economy really doing? Hopefully next week’s heavy data calendar and testimony by Federal Reserve Chairman Ben Bernanke will shed more light on the state of the US economy and monetary policy. With the exception of producer prices, we expect more dollar bearish news and would actually be surprised if Bernanke had anything positive to say about the US economy. The Federal Reserve has cut interest rates by 225bp since August and it will be interesting to see if this has helped existing or new home sales in the month of January. According to the NAHB housing market index, bottom fishers are slowly beginning to sniff out the inventory, but just because they are sniffing do not mean that they are buying. Durable goods, fourth quarter GDP, personal income, personal spending and the Chicago PMI reports are also expected to be released, which means that a volatile week is in store for the currency market. There is a good chance that another round of weak US economic data could drive the US dollar to a record low against the Euro. We continue to believe that the next 2 months of retail sales and non-farm payrolls data will be particularly weak because the last time that we have seen service sector ISM fall to the levels that it did back in January was in 2001 and at that time, non-farm payrolls dropped 300k. In some ways, the latest crisis to the US economy is worse than 2001 which means that the 17k job loss that was reported by the Labor Department in January could pale in comparison to the losses that we could see in February and March. The same can be said for retail sales. Food prices have been on a tear, forcing many consumers to count their pennies at the supermarket. Milk prices alone have increased 15 percent since the beginning of last year. However amidst all of the bad news, there is some good. Many traders are expecting a V-shaped recovery in the US economy in the second half
of the year. According to the profit forecasts for the S&P 500, a 19 percent increase in earnings is expected in Q3. Traders have also piled into steepener trades in the bond markets which mean that they expect yields to rise again a few months forward. This plays into our view that the US dollar will recover in the second half of the year.

New Zealand Dollar Nears 22-Year High, Australian Dollar Trails Behind, Canadian Dollar Behind the Curve
Despite the lack of any economic data, the New Zealand dollar rallied over 1 percent against the US dollar, leaving it within a few pips of its 22-year high. With 8.25 percent interest rates, many people argued that it was just a matter of time before we saw a strong breakout in the New Zealand dollar. The power of today’s move suggests that a new multi-decade high will be made in the currency early next week even though the only piece of market moving data from New Zealand is not due for release until Thursday. The Australian dollar continued to gain strength, but the rally could lose steam as the calendar next week is completely devoid of any Australian economic data. The Canadian dollar on the other hand weakened marginally against the US dollar after a disappointing retail sales report. Like New Zealand, there are no Canadian releases until the end of next week.

Euro: Still Headed for All-Time Highs
The EUR/USD is aiming for its record high and today’s Eurozone economic data is certainly helping to fuel the rally. Despite the slowdown in the global economy, the advance release of Eurozone PMI indicates that the economy is still holding strong, which may lend a bullish tone to next week’s economic data. Traders will be looking to the German IFO report, retail sales, unemployment and the Euro-zone retail PMI and CPI figures for further clues to when the bank will begin to cut interest rates. Comments from ECB member Gonzalez Paramo today suggests that any rate cut from the ECB will not come until the second half of the year. Like some of the other members of the central bank, Gonzalez Paramo believes that “all in all the fundamentals of the euro zone economy remain sound.” The futures market is still pricing in 50 to 75bp of easing by the ECB in 2008, but the price action in the Euro has yet to reflect that sentiment.

British Pound: Can the Gains be Sustained?
After yesterday’s strong retail sales number and blockbuster recovery in the British pound, the currency continued to see a broad based recovery. The outlook for the British pound has become extremely uncertain with a hawkish Quarterly Inflation report, strong retail sales and an upside surprise in employment conflicting with the dovish minutes from the most recent Bank of England meeting. That is why next week’s UK GDP, housing numbers and GfK consumer confidence will be very important because they provide more information on the recent health of the UK economy.

Carry Trade Recovery Limited by Continued Volatility in Equities
News that a bank bailout plan for bond insurer AMBAC will be announced Monday or Tuesday triggered a 200-point reversal in the Dow. Unsurprisingly, the move had only a limited impact on carry trades. Although the correlation between carry and equities is continue to fade, the one thing that remains unchanged is the fact that the volatility in the equity market is a big reason why carry trades have been unable to muster a sustainable rally. This relationship should be the main focus of yen traders. Meanwhile there will be a lot of Japanese economic data due for release in the week ahead including retail trade, industrial production CPI and overall household spending. These reports should only have a limited impact on the Japanese yen.

Kathy Lien is the Chief Currency Strategist at FXCM.