US Dollar Strengthens Further - US Retail Sales Forecasted to Contract for Sixth Straight Month

The US dollar remained strong across the majors as risk aversion remained in play following a speech by Federal Reserve Chairman Ben Bernanke. The bulk of Chairman Bernanke’s speech focused on the causes of the financial crisis, the Federal Reserve’s policy responses, and the differences between the Federal Reserve’s credit easing efforts and the Bank of Japan’s quantitative easing efforts between March 2001 and March 2006, which have been widely deemed unsuccessful. Looking forward, Chairman Bernanke said that if President-elect Barack Obama does indeed implement a large fiscal stimulus package, it is likely to provide a “significant boost” for the economy, but in order to promote a long-lasting recovery the plan must include measures to “further stabilize and strengthen the financial system.” Additional assistance may be needed in the form of more capital injections, guarantees, and efforts to remove toxic assets off the books of financial institutions, which happens to be the original intention for the Troubled Asset Relief Program (TARP). Of course, such efforts will not be readily accepted by the public, and Mr. Bernanke urged politicians to convince their constituents that financial stabilization is necessary for economic recovery.

Looking ahead to Wednesday, the Commerce Department is forecasted to report that US retail sales fell negative for the sixth straight month in December. This is particularly negative because the holiday shopping season is supposed to be a boon for retailers, but even the most aggressive discounting wasn’t able to offset the impact of a deteriorating labor market, tighter credit conditions, and a year-long recession. More specifically, advance retail sales are anticipated to have contracted 1.2 percent during the month, and excluding auto sales are expected to have slumped 1.3 percent. We’ve already heard disappointing results from a variety of sources, including Mastercard’s SpendingPulse survey, which showed that holiday spending tumbled 4 percent in December from a year earlier (excluding gasoline). As a result, another contraction in advance retail sales is likely, and these may mark a rather consistent trend through the first half of 2009 as well. As we saw with US non-farm payrolls, the impact of a disappointing result may be limited, as the Federal Reserve has already cut the fed funds target to a record low range of 0.0 percent - 0.25 percent and has no room to cut further.

Euro Breaks Below Key Support as Markets Price in 50bp ECB Rate Cut This Week

The euro fell yet again versus the US dollar and Japanese yen on Tuesday, but managed to hold up against the relatively weak British pound and commodity dollars. Focusing on EUR/USD, the pair broke below key support at 1.3301, leaving the pair susceptive to declines toward 1.2915 - 1.3000. As mentioned in the US dollar section, risk sentiment remains one of the bigger drivers of price action, so where EUR/USD goes from here may depend more on demand for safe-haven assets like the greenback. From a fundamental perspective, though, downside risks linger for the euro as the European Central Bank is expected to cut interest rates on January 15 by 50 basis points to 2.00 percent to match the 2005 record low. This easily leaves the 7:45 ET announcement as one of the most important pieces of event risk next week, but traders will also have to look out for comments by ECB President Jean-Claude Trichet during his post-meeting press conference at 8:30 ET. Mr. Trichet is one of the most opinionated central bank chiefs around, and suggestions that the ECB will continue to cut rates have the potential to lead the euro far lower. On the other hand, if the ECB goes the route of the BOE and signals that they may leave rates unchanged during their next meeting, the currency could actually rally.

British Pound Tumbles Lower as UK Trade Deficit Widens to Record, House Prices Plunge

The British pound continued to tumble toward its December and January lows near 1.4400 as lingering risk aversion weighed on the more volatile currencies and on the tails of disappointing UK economic data. Indeed, the global economic slowdown has taken a toll on trade for the nation, as the UK trade deficit unexpectedly widened to a record 8.3 billion pounds during November. A 5.8 percent drop in exports of oil, chemicals, and cars were responsible for the deficit, as imports also fell by 1.8 percent, and also suggest that harder times are yet to come for the manufacturing sector, which has already had to slash output. Conditions in the housing sector remain bleak as well given the 8.6 percent drop in the Department for Communities and Local Government’s (DCLG) UK house price index during November from a year earlier. This actually marks the sharpest decline since the DCLG started keeping record in 2002. Overall, this underpins the case for the Bank of England’s policy actions last week, when they cut the Bank Rate to the lowest level since the bank was founded in 1694. Nevertheless, actual rate cuts are having little impact on the currency markets, as traders are more focused on comparative long-term interest rate expectations and risk trends. There will be no key UK economic indicators released this week, making it all the more important to watch the latest return of risk aversion, which tends to work in favor of US dollar and Japanese yen strength.

New Zealand Dollar, Australian Dollar Take a Hit as Demand for Yield Drops

The commodity currencies - which include the Canadian dollar, New Zealand dollar, and Australian dollar – all fell back yet again on Tuesday but the higher yielding ones were hit the hardest. The Australian dollar, with a yield of 4.25 percent, tumbled nearly 3 percent against the greenback while the New Zealand dollar, with a yield of 5 percent, plummeted over 4.5 percent. This is typical of deleveraging and waning risk appetite in the markets, and the Australian dollar faces additional bearish potential tomorrow night as the Australian unemployment rate is anticipated to pick up to 4.5 percent from 4.4 percent while the net employment change is forecasted to fall negative for the second straight month by 20,000. The latter report tends to have a greater impact on the Aussie since the figure rarely meets expectations and can lead to volatile short-term price action for the Australian dollar immediately following the news at 19:30 EDT.

Terri Belkas is a Currency Strategist at FXCM.