US Dollar, Japanese Yen Pull Back as Evidence Points Toward Some Stabilization in Housing

The US dollar was easily the weakest of the major currencies on Tuesday, as the DXY Index pulled back from key resistance. Looking at the major currency pairs, both EUR/USD and AUD/USD rebounded from rising trendlines extending from their October lows at 1.2705 and 0.6300, respectively, while USD/CAD pulled back from the combination of psychological and Fibonacci resistance at 1.2500. The Japanese yen was also a laggard, suggesting risk trends are still driving price action in the forex markets but that the weak US dollar was the greater driver today. There was a bit of positive news on the US economy, as the National Association of Realtors (NAR) reported that contract signings for the purchase of previously owned homes surprisingly jumped 6.3 percent in December, which was much better than forecasts for a flat reading. This is the first time in 4 months that the index has improved, and as we noted yesterday, the rise is in line with the gains in the NAR's existing home sales release last week which also reflected sharp declines in prices. While it is far too early to say that the US housing collapse may be nearing an end, these indicators do suggest that we’re starting to see a stabilization in demand for previously owned homes. New home sales, on the other hand, are likely to remain dismal.

Looking ahead to Wednesday, data is likely to show that conditions in US non-manufacturing sector - which accounts for approximately 70 percent of total economic activity in the country and includes retail, services, and finance - worsened in January. The Institute for Supply Management’s services index is estimated to fall to another record low of 39.0 from 40.1, just above the record low of 37.4 reached in November. Indeed, consumer confidence remains exceptionally weak, as the Conference Board’s measure also fell to a record low of 37.7 during the same month. We already know that the US economy fell into recession in December 2007, but this data will help to gauge how long the recession will drag on for. Since risk trends have proven to be the greater driver of price action in the forex markets, a weaker than expected result could trigger flight-to-quality and thus, gains for the US dollar. Meanwhile, a surprisingly strong result could boost equities and weigh on safe-haven assets.

Euro Bounces from Key Support, Breaks Above 1.30

The euro surged throughout the day on Tuesday due primarily to US dollar weakness, as the currency actually fell against the high-yielding Aussie and New Zealand dollars and ended the day virtually unchanged versus the British pound. There was little in the way of news released from the Euro-zone, but looking ahead to Wednesday, Euro-zone retail sales will be released for December and are expected to decline by as much as 0.2 percent for the month while the annual rate could remain negative at -1.4 percent. With job losses climbing and credit conditions still tight, retail sales are expected to weaken throughout the first half of 2009. If the release proves to be more disappointing than forecasts, the news could push the Euro lower on speculation that the European Central Bank will cut rates on Thursday. On the other hand, a holiday-spending boost to the index could lead to stronger-than-expected results and gains for the currency. As it stands, Credit Suisse overnight index swaps are pricing in virtually no chance of a rate cut, as comments by ECB President Jean-Claude Trichet following their last meeting signaled that the ECB will hold off until March before considering reducing rates again. From a technical perspective, falling trendline resistance could come into play near 1.3200/50 and may be the next target for EUR/USD as long as risk appetite remains stable.

British Pound Rockets Higher Against Dollar, Japanese Yen as Darling Indicates UK is Open to Bad Bank Plan

The British pound surged versus the US dollar and Japanese yen on Tuesday due primarily to increased demand for “risky” assets, and the moves have left the door open for potential GBP/USD gains toward 1.50. Meanwhile, Chancellor of the Exchequer Alistair Darling said during a during testimony to the House of Lords Economic Affairs Committee that the government has “not closed the door on a bad bank scheme” as they continue to grapple with how to deal with toxic assets. At this point, the UK is working with a scheme to have banks take up government insurance against their expected bad debts in the hope that this will lead them to lend at more normal levels. The introduction of new measures would not be surprising though, as Mr. Darling said that they must consider “a range of options.”

Australian Dollar Holds Up Despite RBA Rate Cut

The Australian dollar held up quite well following the Reserve Bank of Australia’s 100 basis point rate cut on Monday night, as the reduction was in line with expectations. Furthermore, the RBA’s subsequent policy statement contained a decidedly neutral policy bias, as RBA Governor Glenn Stevens said that their past rate cuts and “fiscal policies now in place will help to cushion the Australian economy from the contractionary forces coming from abroad.” This indication that the central bank would leave rates unchanged at 3.25 percent going forward led AUD/USD to bounce from support at 0.6350 up to 0.6500 during the US trading session. There will be some event risk on hand for the Australian dollar overnight as retail sales in Australia are forecasted to have grown 0.3 percent during December, confirming that 2008 was a year of lackluster consumption for the economy. Any increases are likely to be solely the result of spending on food, as sales of apparel, household goods, and at restaurants have been consistently weak throughout the second half of the year. Regardless, a reading in line with or more than expectations could lead the Australian dollar to rise overnight, but if the index unexpectedly falls negative, the currency could tumble as the markets will shift to price in greater potential for further rate cuts by the Reserve Bank of Australia.

Terri Belkas is a Currency Strategist at FXCM.