Dollar – 1.50 Broken, Now What?
It finally happened. After three failed attempts over the past several months the EURUSD broke the 1.5000 barrier and barreled to 1.5200 as the case for decoupling became clearer by the day. US economic data continued to disappoint sinking to a six year low while EZ data produced mainly upside surprises. As we’ve said many times before, much to the consternation of euro bears the EZ economy is not crumbling despite disadvantageous exchange rates, high energy costs and a restrictive monetary policy.

The greenback on the other hand was further pummeled by Chairman Bernanke’s dour testimony which suggested that the Fed will continue to lower rates, irrespective of the massive inflationary risks building up within the US economy. The chairman repeatedly stressed the need for “balance” essentially telegraphing to the markets that the Fed is far more concerned with stimulating growth rather than controlling price pressures. The net effect of Dr. Bernanke’s rhetoric was more dollar liquidation as traders now fully expect a 50bp cut in March which would widen the spread between the dollar and the euro to 150bp in euro’s favor.

Next week the market will get a glimpse at the latest US ISM data from both services and manufacturing . It will be interesting to see if the decline in the dollar will have any positive impact on exporters, but as of now the consensus estimate is for the survey to slip below the 50 boom/bust line into contraction territory. The key event risk however will occur on Friday when traders see the NFPs for February. Markets are looking for a tepid albeit an improved print of 40K. However, given the very negative trend in weekly jobless claims which have averaged more that 350K for the past four weeks, a second straight month of job losses could well be the outcome. Should that occur, the dollar could tumble even more.

Euro – Friendly Data Helps
While US data offered nothing but the dour drumbeat of disappointment, the economic news from the EZ was decidedly more friendly this week. The IFO report printed at 104 taking the market by surprise since most were looking for a lower reading of 102.8. Last week we noted that IFO may be the key determinant of direction in the pair, stating that, “If the IFO does indeed show significant weakness, all the hand wringing about ECB being too hawkish could drive the pair right down to the bottom of the recent range. However, should IFO remain at last months levels the case for decoupling will only grow and the pair could make a run to new highs as the decupling thesis will be confirmed.”

With growth in the EZ clearly not slowing nearly as badly as in US, the markets finally came to the realization of our often stated contention that the ECB will remain at 4% far longer than the consensus believes while the Fed will be forced to reduce rates consistently for the rest of the year. Once that idea became accepted by the vast majority of participants, the floodgates opened and 1.5000 figure fell by the wayside.

Next week, the EZ calendar will be relatively quiet with only the ECB meeting a possible market mover. No one expects the ECB do anything but remain stationary. However, the always colorful ECB chief Jean Claude Trichet will be hard pressed to defend the bank’s unrelenting hawkishness. If he acknowledges the risk of an slowdown in the EZ economy, EUR/USD could come in for some profit taking as traders will anticipate that Mr. Trichet is setting up the market for a possible rate cut in Q2 of this year. On the other hand if Mr. Trichet remains resolute in his emphasis on price stability, the euro express will continue to roll.

Yen Surges to Three-Year High as Investors Dump Risk
Though it couldn’t set the same exorbitant records as the Swiss franc, the Japanese yen put in for an astounding move of its own over the past week. In the last four days of the week, the Japanese currency plunged over 400 points against its well-weathered US counterpart – the sharpest USD/JPY decline since the massive drop through the end of December/beginning of January. So what instigated such a notable rise in interest for the FX market’s funding currency? Risk. There were a number of influences throughout the market that would ultimately play into the eventual flight from risk; but the real momentum would begin with a number of notable earnings reports. On Thursday government-sponsored, US mortgage finance company Freddie Mac reported its largest loss on record over the fourth quarter. This is notable as Freddie Mac, along with its sister organization Fannie Mae (which previously reported a record loss of its own), account for 45 percent of the $11.5 trillion home loan market. This is certainly a blow to any rebound in confidence for the troubled credit market. On Friday, what optimism had lingered was completely snuffed out when Blue Chip insurer AIG reported an $11 billion writedown. This represents yet another step in the progression of the credit crunch from subprime, to mortgage lenders, to hedge funds, to investment houses, to bond insurers and now standard insurance. How far can it go?

And, despite risk’s tether to the Japanese yen, the fundamental calendar was altering growth and interest rate expectations in the background. The cooling in demand from major consumption economies like the US had a major impact on the factory activity in Japan according to the preliminary reading of January industrial production which dropped 2.0 percent. The consumer is fairing little better. Though overall household spending and retail trade rose over the same month, the improvement can be attributed primarily to high prices rather than a greater number of purchases. Further weighing on Japanese consumers’ wealth, housing starts continue to drop in a mirroring of the US and UK housing markets. And, though the brakes seem to be firmly pressed on growth, inflation trends have increased. The annual reading on National CPI held at a decade high last month – teasing traders with a hike just out of the BoJ’s reach.

For the week ahead, risk trends will almost certainly take the helm for the yen’s bearing. There are a number of credit market-related issues that have yet to be resolved – like the credit worthiness of MBIA and the pending plans to rescue AMBAC – which could sink or revive lending. And, when the winds of risk recede, the economic calendar will be there to fill in for the lull. The first notable market mover is the labor cash earnings report for January which will offer a sense of confidence and spending for the months ahead. The fourth quarter capital spending report has been a consistent mover in the past and it is sure not to let traders down on Tuesday evening. Finally, the BoJ rate decision and leading economic indicators index will round out the latter half of the week with broad views of interest rates and growth.

British Pound Recovers as Inflation May Prevent BOE Rate Cut in March
The British Pound finished the week with relatively unimpressive gains against the anemic US dollar and was the fourth-worst performer among all G10 currencies. Sterling bulls initially sent the currency to fresh 3-month highs, but a later reversal in risk sentiment clearly hindered the recently risk-sensitive GBP/USD. Fundamental developments hardly bolstered outlook for the British Pound; a trio of lackluster GDP revisions, GfK Consumer Confidence figures, and clearly disappointing Nationwide House Prices numbers reignited fears of a noteworthy domestic economic slowdown. Indeed, many cite the fourth-consecutive decline in the closely-followed Nationwide House Prices report as clear evidence that the UK may be in the early stages of a housing recession on a similar scale to that of the United States. GfK Consumer Confidence data certainly suggests that the consumer sees little hope in current and future economic conditions, and it remains to be seen that the UK can sustain above-trend growth amidst a broader slowdown in the global economy. Subsequently gloomy forecasts for the future of UK economic expansion should, all else remaining equal, leave a similarly bearish outlook for the future of domestic interest rates. Yet the Bank of England has clearly expressed concern on price pressures in Europe’s second-largest economy—leaving GBP rate expectations stable through the medium term.

A highly-anticipated Bank of England Rate Decision will likely be the highlight of British economic event risk in the week ahead, and any surprises could easily force GBP volatility. A survey by Bloomberg News shows that 59 of 60 analysts surveyed expect the BoE to leave rates unchanged at 5.25 percent. Such a clear consensus arguably leaves risks to the topside for the GBP/USD, but we cannot categorically rule out a BoE rate move through the coming months. The Bank does not typically release statements following decisions to leave interest rates unchanged, but we likewise saw that officials felt it necessary to release a post-announcement communiqué following a fairly recent BoE meeting. Any such text would very likely drive volatility and short-term direction in the GBP. Else the British currency will trade off of relatively less-significant PMI Manufacturing, Construction, and Services results. It will be important to watch for any significant shifts in global risk sentiment. Despite the fact that the British Pound has effectively lost its spot among the top-three yielding G10 currencies, the GBP remains correlated to global risky asset classes. We will watch for any further drawdowns in the Dow Jones Industrial Average and other key equity indices, as they may force similar losses in the Pound Sterling.

Swiss Franc Largest Gainer Among Entire Universe of Currencies
The Swiss Franc had a week to remember, as it outperformed the entire universe of global currencies and set fresh record highs against the US dollar. A 4.2 percent 5-day rally is virtually unheard of in the currency world, and such dramatic movements clearly underline bullish sentiment for the comparatively low-yielding currency. Yet we saw relatively little in the way of fresh economic developments out of the landlocked European economy; it seems as though a spike in global risk aversion was the main culprit behind the Swissie’s surge. Indeed, the similarly risk-sensitive Japanese Yen posted similar moves and jumped 3.4 percent against the downtrodden US dollar. The Swiss Franc’s virtually unabated rally arguably leaves it susceptible to noteworthy corrections, but recent CFTC Commitment of Traders data suggests that relatively low levels of Swiss Franc long positions (USD/CHF shorts) could allow the currency further rallies through the medium term.

According to CME futures data, the level of speculative (non-commercial) Net Longs on Swiss Franc contracts remains in neutral territory. Typically we see that such strong rallies produce overbought conditions in any given currency—signaling that a short-term correction is due. Yet a combination of healthy positioning and a steadily improving Swiss Franc-US Dollar interest rate differential suggest that short and medium term risks remain to the upside for the CHF (downside for the USD/CHF). Barring a sharp improvement in US dollar sentiment, we feel that overall fundamentals favor further lows in the USD/CHF.

Looking at foreseeable economic event risk, Swiss Franc traders will look to Consumer Price Index data and Unemployment Rate numbers to clarify outlook for the domestic economy. Consensus forecasts show that traders predict Consumer Price Index numbers will likely remain elevated at 2.4 percent—leading many to believe that the Swiss National Bank may actually raise interest rates in 2008. Despite downside risks to economic growth, the inflation-targeting central bank may feel forced to tighten monetary policy with CPI inflation at 14-year highs. Markets have not yet priced in SNB rate hikes, but an above-consensus print in Tuesday’s CPI data could certainly bolster the case for higher SNB interest rates in 2008. The Swiss Franc would almost certainly trade off of any surprises in the aforementioned data releases, while general developments in the US dollar and global risky asset classes may have similarly pronounced effects on the USD/CHF exchange rate.

Canadian Dollar Reverses Gains as Expected Rate Cut Approaches
There was little scheduled data on the economic calendar last week, but that didn’t dampen volatility in the Canadian dollar. From the very open of the trading week, the loonie began in its steady advance against the US dollar. In four days, USD/CAD would demolish a three-month old, consistent trend channel, plunge 415 points and set a new three-and-a-half month low just above 0.9700. And, though the pair would put in for the beginnings of a rebound on Friday, the week’s trend was clearly called. That leads us to the natural question of what would lead to so much strength when so few indicators were crossing the wires? We can look for an answer in the currency market. Looking around, there were other notable rallies that turned at the end of the week for the Australian and New Zealand dollars. This would suggest commodities were at least partially responsible for the loonie’s strength. Looking to those natural resources that normally have a strong correlation to the USD/CAD, we find that gold closed Friday at a record high $975/ounce and crude has officially closed above $100/barrel.

While commodities may have ruled most of the week, they did so only because notable economic data was allowing the asset class free rein over the currency. In fact, when the week’s only notable fundamentals crossed the wires on Friday, the market seemed to take note and finally bring the loonie back to earth. Upstream inflation pressures roused some suspicion when raw material prices through January surged 3.4 percent. Matching a six-month high, this could have been taken as a sign of higher consumer prices to come; but with gasoline and food prices have risen so consistently over the past months, such a shift was likely priced in. Perhaps more surprising was the fourth quarter current account release. Though economists came close with their forecast, the C$500 million deficit held too great of an implication for growth and the Canadian dollar to be ‘fully’ priced in. The first deficit in 9-years is irrefutable proof that trade is suffering from a currency that is stubbornly holding below parity against its US counterpart. And, as trade was the primary engine for accelerating growth to its impressive run over the past year, it seems only fitting that it will also be responsible for putting on the breaks.

This week, the Canadian dollar will switch gears. Instead of commodities and a lame dependency on the US dollar, the currency will be driven by the most active economic calendar among the majors. The fundamental action begins immediately on Monday with a December and fourth quarter GDP release. The monthly number is expected to report the first contraction 15 months which would likely contribute to the weakest pace of annualized growth in four-and-a-half years. If expectations are met and these lows are confirmed, it wouldn’t be out of the question for the market to speculate that the Canadian economy playing catch up to the US. If that’s true, Tuesday’s BoC meeting could result in a 50 bp cut instead of the 25 bp cut expected. A building permits and Ivey PMI report will fill in for the lull of the week before the consistently market moving employment data crosses the wires. A 5,000-person forecasted pickup is ominously close to a contraction.

RBA Rate Decision Will Try to Return Aussie to Recent Record High
The Australian dollar has come a long way in six weeks. Back in the latter half of January the Aussie dollar was testing a four-month low against the benchmark greenback around 0.85. Since then AUD/USD has rallied an astounding 1000 points. The most recent leg of this incredible rally was carried by a general demand for risk, a rally in commodities and the market’s feature interest rate outlook. The appetite for risk was whetted through the previous week when stories printed that the troubled monoline insurers’ credit ratings would be secured. This in turn calmed credit market fears and led to a rally in all assets closely related to risk trends. Another carry over undercurrent from previous weeks was the outlook for the Reserve Bank of Australia. Speculation for a second quarter-point rate hike has been growing ever since the last bump to 7.00 percent. And, joining the mix this past week was a new intensity behind commodities as energy and gold prices forced record highs and closely-watched psychological levels. Through Thursday, this trio carried AUD/USD another 250 points to a new 24-year high just below 0.95. However when the credit market support began to fall apart and commodities lost momentum, Aussie traders rushed to take profit in the overbought currency, subsequently sending AUD/USD tumbling 175 points on Friday alone.

Outside of the influence of exogenous fundamental influences, the economic calendar was dotted with a mix of notable, second tier releases. The data started out weak as fourth quarter construction activity unexpectedly drop 1.0 percent, with contractions in both residential and non-residential structures. On the following day, the Conference Board leading index (used to forecast growth over the coming three to six months), was a little more impressive. Though the 0.2 percent pickup was small, it was the fifth consecutive improvement. Then the fourth quarter private investment report boosted confidence with a greater than expected 5.1 percent jump in business investment – mainly from China. Finally, the pace of lending in the private sector reportedly held near its multi-decade high despite the problems in the credit market.

Looking ahead to the week ahead, the risk sentiment and commodities could once again take up their influential stations over the Australian currency. However, unless the trends are amazing, the economic calendar will most likely have its way with the currency. Unlike last week where the calendar was lined with second string reports, this week’s headliners are retail sales, the fourth quarter current account balance, annualized GDP for the end of the year and a potentially explosive RBA rate decision. The RBA clearly tops the list as the market has been anticipated another quarter point hike for a month now. However, if when the dust clears, the central bank meets expectations, the market will then turn back to forecasting future policy decisions and the general health of the Australian economy. The 4Q growth report is expected to cool modestly, but a surprise here can dramatically alter the future of the Australian dollar.

New Zealand Dollar Worst Performer in G10 on Risk Sentiment
The New Zealand dollar was the only G10 currency to lose against its perpetually downtrodden US namesake, as a clear deterioration in global risk sentiment forced sizeable declines in the carry trade-linked currency. The NZD had initially remained largely rangebound on a virtually empty New Zealand economic calendar, but a key failure at psychologically significant resistance levels left it especially susceptible to a noteworthy retracement. What happened next was nothing short of extraordinary; the New Zealand dollar lost an incredible 3.5 percent against the Japanese yen through the last day of forex trading. A 315 point rout in the US Dow Jones Industrial Average clearly played a part in the NZD unwind, and all risky asset classes saw a panicked flight to safety to end the week’s price action. Given downside risks to the Dow and other major indices, we would argue that risks remain similarly to the downside for the Kiwi and other high-yielding currencies. Yet an upcoming Reserve Bank of New Zealand Official Cash Rate announcement may likewise dictate short-term price action in the recently volatile NZD/USD currency pair.

Any surprises out of the upcoming RBNZ rate announcement could almost certainly drive sharp volatility across Kiwi pairs, and traders may show little willingness to force major NZD moves ahead of the news release. A recent Bloomberg News poll shows that all 15 of 15 analysts surveyed believe that the RBNZ will leave rates unchanged at a record 8.25 percent. Yet recent inflation data suggests that risks remain to the upside for the future of New Zealand interest rates. Given the RBNZ’s strict inflation-targeting policies, Governor Alan Bollard may have little choice but to tighten the reins on domestic price pressures. Any interest rate hikes would only improve the Kiwi’s impressive yield advantage against all G10 counterparts, but such high yields likewise leave it susceptible to sharp shifts in global risk sentiment. Recent price action clearly underlines the NZD’s sensitivity to major equity markets and other similarly correlated asset classes, and as such traders will have to gauge overall direction in equities in order to play the ‘right’ side of New Zealand Dollar volatility.

Boris Schlossberg is a Senior Currency Strategist at FXCM.