Softer Inflationary Pressures Fail to Stifle the Dollar’s Gains
The US dollar extended its gains against every major currency. Softer consumer prices have failed to stifle the dollar’s recovery as the market wonders how much longer producers will be able to bear the brunt of higher prices. Core prices increased by only 0.1 percent last month while headline prices increased 0.2 percent. A decline in housing rentals dragged core inflation down while the biggest jump in food prices in 18 years pulled headline CPI higher. The Federal Reserve may feel a bit more relaxed after seeing these inflation numbers, but the underlying increases can still be worrisome. Risk appetite is steadily returning to the markets and that is being reflected in the movement of the Dow and carry trades. The stock and credit markets have been stabilizing over the past few months and thankfully, no bank has fallen victim to the same type of demise as Bear Stearns. According to an article in the Wall Street Journal today, “a growing number of economists — including some who not long ago were saying a recession was all but inevitable” are now taking a detour. The 325bp of easing delivered by the Federal Reserve and the distribution of fiscal stimulus checks has forced many economists to reduce their odds of a recession. Economic data has also been stabilizing while volatility has been declining. However the ongoing rise in gasoline prices, falling house prices and the increasing level of foreclosures poses a big risk for consumer spending in the months ahead. Whenever volatility in indices like the VIX hits such extreme levels, a reversion to the mean may be right around the corner. There are a lot of US numbers due for release tomorrow including the Philadelphia Fed index, industrial production and the Treasury International Capital flow report. The weak dollar should bring improvements in the manufacturing sector, but foreign purchases of US securities may have been weak because the data is for the month of March, when Bear Stearns collapsed.

Euro Left Out of the Action
Big swings have been happening across the currency market but unfortunately the Euro has been left out of the action. Since the beginning of the month, the currency pair has been trapped within a tight range and that range contracted to less than 100 pips today. Both French consumer prices and Eurozone industrial production fell short of expectations, but that failed to have a meaningful impact on the Euro. The volatility in the currency should pick up tomorrow with the French, German and Eurozone GDP reports due for release. Trade and consumer spending actually improved in the first quarter which should help to boost the GDP numbers. Like the rest of the world, ECB officials are extremely uncomfortable with the level of inflation and according to ECB member Ordonez, the central bank will not be able to tolerate the current level of inflation forever. Meanwhile the FXCM SSI has been flipping back and forth with the current positioning of the Euro at parity. This confirms the range trading behavior of the currency pair. Switzerland’s SECO Consumer climate survey is due for release tomorrow. Consumer confidence is expected to decline given the slowdown in the global economy.

British Pound Hits 2.5 Month Low
The British pound hit a 2.5 month intraday low against the US dollar following the release of the UK employment report and the Bank of England’s Quarterly Inflation report. For the third month in a row, the number of people claiming unemployment benefits has increased which is a reflection of the softer labor market. Interestingly enough wages actually rose by 4.0 percent, the highest level since November. The surprise came primarily from bonuses because earnings growth excluding bonuses remained at 3.8 percent. According to the RICS, the house price balance fell to the weakest level on record as prices decline across the country. These numbers shifted the market’s focus away from the BoE’s concern about inflation and onto their prospects for growth. Even though inflation is expected to remain well above their 2 percent target for the remainder of the year, the Bank of England revised down their GDP forecasts for next year from 1.6 percent to 1 percent. This is a huge alteration and reflects their degree of pessimism.

Triple Blow to Commodity Currencies
The Australian, New Zealand and Canadian dollars have weakened across the board as the US dollar extended its gains, commodity prices pared back and economic data disappointed. Despite a strong labor market, wage growth in Australia slowed in the first quarter while foreigners reduced their holdings of New Zealand bonds. The New Zealand dollar has weakened significantly over the past few months, having just hit a fresh 3-month low against the US dollar this morning. New Zealand retail sales and the business PMI report are due for release this evening followed by the Australian consumer inflation expectation and weekly wage report. Even Canada has their manufacturing shipments report due for release, so expect some continued volatility in the commodity producing countries.

USD/JPY Breaks 105, But Will the Move Continue?
USD/JPY broke above the psychologically important 105 level but has failed to sustain its gains. At the end of the US trading session the currency pair was fluctuating around the big figure and now looks vulnerable to more losses, especially given the fact that the Dow has retraced more than half of its gains. The market has given little weight to the stronger than expected Japanese economic data. The current account surplus increased in the month of March as well as the CGPI in the month of April. Machine orders are due for release this evening, but that should only have a nominal impact on the yen.

Kathy Lien is the Chief Currency Strategist at FXCM.