US Dollar, Japanese Yen Pull Back as DJIA Ends Day in Positive Territory

The US dollar and Japanese yen both saw sharp reversals of their rallies from Thursday, as a pickup in risk appetite worked in the favor of higher-yielding currencies and “riskier” assets like stocks. There were a few aids to the rise in investor sentiment, as the government provided a package of guarantees, liquidity access, and capital to Bank of America worth $138 billion in order to help them along with their acquisition of Merrill Lynch. Meanwhile, the US Consumer Price Index (CPI) slowed to an annual rate of 0.1 percent, the lowest since 1955, but was actually higher than forecasts for a decline to -0.2 percent. While this is still clearly a very low figure historically, the fact that the index remained positive helped to assuage concerns that the economy had fallen into deflation.

Finally, the Reuters/University of Michigan consumer confidence index unexpectedly rose to 61.9 in January from 60.1. Sentiment on current conditions and the economic outlook remained bleak, but the latter did see a slight increase as the US is likely to come to agreement on a fiscal stimulus plan amounting to $825 billion within weeks. However, inflation expectations for 1-year ahead and 5-years ahead both rose to 2.0 percent and 3.0 percent, respectively, as gasoline prices started to climb again at the start of the month. Looking ahead to the next week, there will be no top tier indicators released from the US, leaving risk trends as the dominant driver of the forex markets.

British Pound Holds Solid Link with Carry Trades - BOE Minutes, Q4 GDP Could Make or Break GBP/USD Next Week

The British pound may have fallen through most of the US trading session, but it still managed to end the day higher against the greenback. The UK’s currency has been one of the most volatile of the majors, which is unsurprising once you consider the British pound’s rising correlation with the G10 carry trades. Event risk will pick up significantly next week as two indicators will provide key insight into whether or not the Bank of England will cut rates again in February. On January 21 at 4:30 ET, the Bank of England’s meeting minutes will hit the wires and tend to be a huge market-mover for the British pound, and this time is unlikely to be any different. During the January meeting, the BOE’s Monetary Policy Committee (MPC) slashed the Bank Rate by 50 basis points to a record low of 1.50 percent, as expected. However, the British pound subsequently rallied as the MPC did not give any indication that they would cut rates again during their February 5 meeting. The British pound’s response to the release of the minutes will depend on if the MPC’s comments and outlooks signal the same thing: that the BOE will hold a more neutral stance going forward.

On January 23 at 4:30 ET, the advanced reading of Q4 GDP for the UK is forecasted to contract for the second straight quarter at a rate of -1.2 percent, which would match the worst decline in 18 years. The UK has been hit particularly hard by the credit crunch, especially since the country became one of the biggest financial centers in the world. This has translated into a full-on collapse of the housing market, climbing job losses, and weak consumption. Furthermore, with growth slowing around the world, demand for British exports has declined as well, putting a large burden on manufacturers. Overall, a greater-than-expected decline could lead the British pound lower as the data would raise the odds the BOE will cut rates further in coming months. On the other hand, if GDP is even just a bit better than forecasts, the currency could surge.

Euro Edges Higher Despite Thursday’s ECB Rate Cut - 1.34 the Level to Watch

The euro crept higher throughout the day on Friday, despite the release of disappointing European trade results early in the day. The Euro-zone trade deficit widened to a seasonally adjusted 4.9 billion euros in November as exports declined at the fastest pace in more than eight years. Indeed, the global economic slowdown is taking a hefty toll on Europe’s manufacturers, as they also have to contend with waning domestic demand. On the hourly charts of EUR/USD, the pair has established a bear trend from the December highs, but it will be very important to watch where price stands relative to trendline resistance at 1.3400, as a break higher would suggest additional gains are to come.

Looking ahead to the next week, event risk will be relatively low but there are still a handful of indicators worth watching. On January 20, the German ZEW survey of investor sentiment is forecasted to show a slight improvement in opinion on the economic outlook, but a continued deterioration in confidence in the current situation. This is similar to what we saw with the US Reuters/University of Michigan consumer confidence index, which reflected a rise in the economic outlook as the government is likely to come to agreement on a fiscal stimulus plan amounting to $825 billion within weeks. On January 22, the European Central Bank’s Monthly Report is likely to highlight the bleak outlook for the economy and expectations for a decline in inflation pressures in the near-term, all of which created bearish potential for the euro. Finally, on January 23, the Purchasing Managers’ Index (PMI) for the Euro-zone’s services and manufacturing sectors are forecasted to reflect a contraction in business activity for the eighth straight month in January, while the composite index is anticipated to the worst level since recordkeeping began in 2005, highlighting the extent of the recession plaguing the region.

Terri Belkas is a Currency Strategist at FXCM.