US Dollar Weakens As Retail Sales Fall Negative – Will Inflation Data Revive the Greenback?

The US dollar slipped against the euro and Swiss franc on Wednesday, as the dollar index is still holding below a falling trendline which connects the late 2005 – 2007 highs. On the other hand, the greenback fell hard against the high-yielding commodity currencies (see more below) but rocketed higher versus the British pound. Data worked against the currency, as US retail sales fell 0.1 percent in July - marking the first negative reading in five months - as motor vehicle purchases plunged 2.4 percent. Excluding autos, the index rose less than expected by 0.4 percent. Looking at a further breakdown of the report, it appears that the decline in average gas prices from over $4/gallon during the last half of July helped to slow the gasoline station component, which only increased 0.8 percent (compared to 4.0 percent in June and 3.3 percent in May). Overall, the report highlights the fact that retailers are at a particular disadvantage in the current economic scenario, as deteriorating labor market conditions and persistently high energy and food prices limit discretionary income. Nevertheless, the data shouldn’t have a big impact on the Federal Reserve’s current bias, as they are well aware of the downside risks to growth, especially those stemming from consumption.

On Thursday, US CPI will hit the wires at 8:30 EDT and could shake up interest rate expectations if the data misses expectations by a large margin. The headline consumer price index for the month of July is expected to rise to an annual rate of 5.1 percent – the highest since February 1991 – and though a bulk of the increase will likely be the result of food price gains, but there is potential for the pullback in oil prices from its July record of nearly $148/bbl down toward $125/bbl to actually weigh on the index a bit. Meanwhile, core CPI is anticipated to show a mild 0.2 percent rise for the month, which would leave the annualized reading at 2.4 percent. However, if any of these figures surprise to the upside or downside, the markets will respond accordingly and the moves could be dramatic.

British Pound Plummets As Bank of England Offers Bleak UK Outlook

The release of the Bank of England’s Quarterly Inflation Report triggered a 300+ pip selloff in the British pound on Wednesday morning, as the central bank offered a bleak picture of UK economic conditions. Indeed, in the report, the BOE revised their growth projections sharply lower for 2008 – 2009 and even said that GDP could be negative for one or two quarters. Furthermore, while CPI forecasts were revised up toward 5 percent through the end of 2008, the inflation outlook was downgraded significantly from 2009 – 2011. What does this mean for interest rates in the UK? Currently, overnight index swaps are pricing in almost 75bps worth of rate cuts over the next 12 months, compared to approximately 50bps in recent days. However, BOE Governor Mervyn King prepared the markets for the worst as he said the UK economy faces a “difficult, painful adjustment,” suggesting that the head of the central bank will seek to leave rates steady through the end of the year – despite the risk of recession – in an attempt to cool inflation. Once we hit 2009 and CPI starts to pullback, though, interest rates are likely to be cut rapidly. In the near-term, GBP/USD could consolidate above Wednesday’s lows near 1.8650, but I still believe that the pair will ultimately move down for a test of 1.85.

Euro Outlook Hinges Upon Thursday’s Euro-zone GDP Report

The Euro continues to trade just above the 2007 highs near 1.4865 – 1.4900, as price consolidates following the massive declines seen over the past week. Indeed, the markets are now pricing in over 25bps worth of rate cuts by the European Central Bank over the next 12 months thanks to ECB President Trichet’s more dovish tone last Thursday. However, Thursday’s release of Euro-zone GDP and CPI could have a huge impact on these rate expectations, though the former is more important at this juncture. Why? Everyone is already well-aware that inflation is a problem in the Euro-zone, but Mr. Trichet turned the spotlight on the weakening economy last week. Now, if these GDP numbers confirm that a slowdown is plaguing the region (GDP is anticipated to contract 0.2 percent in Q2 and slow to a 1.5 percent annualized pace), the markets will be quick to price in more aggressive rate cuts within the next year, which would be quite bearish for the Euro. On the other hand, if the quarterly rate of growth manages to hold positive and CPI rises in line with expectations to 4.1 percent, EUR/USD could rebound above 1.50.

Commodity Dollars Make a Comeback As Oil, Gold Futures Rally

The Australian dollar and New Zealand dollar both surged during Wednesday’s trading session as commodities such as gold and oil rebounded. Furthermore, as Quantitative Analyst David Rodriguez discussed in his special report, the Australian dollar forecast has improved following the currency’s record consecutive declines, suggesting that the other comm dollars are likely to do so as well. Meanwhile, with the USD/CAD pair consolidating in a range of 1.0625 – 1.0700, Senior Strategist Jamie Saettele pointed out this morning that the Canadian dollar may provide a good risk/reward trade. With little in the way of event risk out of Canada for the remainder of this week, USD/CAD is likely the safest trade to use in order to take advantage of the near-term prospects for the commodity dollars.

Japanese Yen: Choppy Trade In Indecisive Markets

The Japanese yen rocketed high overnight and this morning across the major, but the low-yielder ultimately ended the day lower – especially versus the high-yielding New Zealand dollar – as key JPY cross support levels were hit. Meanwhile, GDP in Japan contracted 2.4 percent in Q2 from a year earlier due to a decline in exports, housing investment, and consumer spending. With global demand anticipated to slow and Japanese consumers grappling with persistently low wage growth and high food and energy prices, there is little hope for expansion to recover in the near-term. Nevertheless, traders should continue to keep an eye on technical levels and risk sentiment, as the Japanese yen tends to trade based on these factors rather than fundamentals.

South African Rand, Turkish Lira Tumble Ahead of Central Bank Rate Decisions

Both the South African Rand and Turkish Lira fell against the US dollar on Wednesday ahead of key rate decisions. The South African Reserve Bank (SARB) is anticipated to leave rates steady at a five-year high of 12 percent following six hikes since last year, while the Central Bank of the Republic of Turkey is forecasted to leave rates at 16.75 percent after hiking during the past three meetings. Indeed, both regions have experienced robust price growth, but with domestic demand starting to wane, they will seek to take less aggressive actions going forward. Traders should keep an eye on any commentary by either the SARB and CBRT following the decisions, as any sort of biased rhetoric will have a large impact on the forex markets.

Terri Belkas is a Currency Strategist at FXCM.