US Dollar, Japanese Yen Fall Back to Key Levels on European-Led Jump in Risk Appetite - US CPI on Friday

The US dollar and Japanese yen ended the day mostly lower on Thursday after sharp declines during the European trading session, but it was clear that risk appetite in the forex markets was on edge during US trading as US economic data r was broadly disappointing, with one "better than expected" indicator proving to actually be somewhat deceptive. Indeed, after pairs like EUR/USD, EUR/JPY, and GBP/USD ran into key resistance around 9:00 ET and 10:00 ET, the JPY crosses simply consolidated while the USD crosses pulled back.

In economic news, the US producer price index jumped by the most in 6 months during the month of January at a rate of 0.8 percent due primarily to an increase in consumer good costs, including women’s apparel, residential electricity, gasoline, prescriptions, passenger cars, and tobacco goods. However, the cost of crude and intermediate goods actually fell in January, at rates of -2.9 percent and -0.7 percent, respectively. This suggests that producers aren’t necessarily passing these lower costs on, and may also indicate that Friday’s release of the US Consumer Price Index (CPI) could be a bit stronger than anticipated. On the labor front (see chart), US initial jobless claims for the week ending February 14 held steady at 627,000 while continuing jobless claims for the week ending February 7 surged to a fresh record high of 4,987,000, signaling that the deterioration in the labor markets is sure to continue in line with the Federal Reserve’s forecasts that the unemployment rate may rise as high as 8.8 percent this year, if not higher. In the meantime, the Philadelphia Fed’s manufacturing activity index tumbled to -41.3 for the month of February, marking the lowest since October 1990. The decline is in line with the drop in the New York Fed’s “Empire” manufacturing index, which also reflected contracting prices, falling new orders, and hefty job losses. Finally, the Conference Board’s leading economic indicator index rose for the second straight month by 0.4 percent in January to 99.5. This was much better than forecasted, but in reality there were few high points in this actual report since the bulk of the gain was due to a 0.54 percent rise in M2 money supply, which has only ballooned over the past 5 months because of the Federal Reserve’s efforts to boost liquidity. Indeed, most other components were disappointing, including the average workweek, jobless claims, building permits, and stock prices.

Looking ahead to Friday at 8:30 ET, the release of the January reading of the US Consumer Price Index (CPI) could lead the term “deflation” to be used abundantly in coming weeks and months. Indeed, CPI is forecasted to have edged a slight 0.3 percent higher during January, while the annual rate is anticipated to have fallen negative for the first time since 1955 by 0.1 percent. Excluding volatile food and energy prices, though, core CPI may have risen 0.3 percent during the month, leaving the annual rate to fall to a nearly 5-year low of 1.5 percent. At the same time, we have to consider the risk that CPI will be stronger than expected. As mentioned above, there is evidence that producers aren’t passing on lower input costs to consumers, and this could translate into a strong enough month-over-month gain to keep the annual rate in positive territory.

Euro Surges on Hopes EU Will Coordinate Efforts to Bail Out Member Nations, Eastern European Banks

The euro surged higher on Thursday to test former support at 1.2725 amidst news that the Euro-zone’s largest economy, Germany, would step up to the plate and help another member nation if they fell into a dire financial situation. During a press conference, German Finance Minister Peer Steinbrueck was asked if the country would risk seeing the Euro-zone break up rather than assist one of its 16 member-states if they were not able refinance its debt. In response, Steinbrueck said, “Could you imagine anyone would be willing to put up with this? We would have to take action.” Meanwhile, ten international banks, including Commerzbank and Unicredit, pledged $2 billion and seven Ukrainian-controlled banks pledged $1 billion in order to recapitalize their subsidiaries in Ukraine as eastern European banks face ratings downgrades and financing difficulties. Overall, these signs that various governments and financial institutions are willing to coordinate their efforts for the greater good, but ultimately, indications of distress in the financial sector will still have very negative repercussions for risk appetite. Looking ahead to Friday morning, Markit Economics is expected to report that the composite Purchasing Managers' Index (PMI) for the Euro-zone's manufacturing and services sectors edged up to 38.5 in February from 38.3. However, since the index may hold below 50 - signaling a contraction in activity - for the ninth straight month in February, it should remain clear that the recession is still deepening. This doesn't tend to be the most market-moving report for the euro, though extremely disappointing figures could exacerbate any weakness in the currency.

British Pound Retraces Bulk of Gains as Risk Appetite Wanes - UK Retail Sales on Friday

The British pound rallied with the euro during the European trading session, but subsequently retraced most of the gains during the US trading session as investor sentiment deteriorate. UK economic news was disappointing, as the UK’s budget surplus was the smallest during January in 14 years at 3.3 billion pounds. Indeed, the January surplus is typically very high as the government collects more than 10 percent of its annual tax revenue that month, and these low results suggest that budget deficits will spiral higher amidst job losses and continued declines in home values. Looking ahead to Friday, UK retail sales figures are forecasted to show another rise in spending during the month of January, and while this could initiate a reaction from the British pound - especially if the reading is significantly higher or lower than estimates - traders shouldn’t read too much into the actual figure. A few months ago, the BOE said that they would not put too much stock into these government statistics as they are often volatile, and instead they look toward private surveys like BRC retail sales.

Canadian Dollar Mostly Lower Ahead of Canadian CPI

The resilience of Canada’s economy has nosedived with oil prices, as the commodity served as the lifeblood of growth for the nation, boosting its trade surplus and providing thousands upon thousands of jobs. However, the combination of lower oil prices and the US recession has led Canada's trade balance to plunge into a deficit for the first time since 1976, according to December’s data. As a result, the Canadian government announced a C$39 billion stimulus plan last month, but from a monetary policy perspective there isn’t much more that the Bank of Canada (BoC) can do as they’ve already slashed rates to a record low of 1.00 percent. Nevertheless, the BoC has left the door open to further reductions, which makes Friday’s inflation numbers important for the country’s interest rate outlook and the Canadian dollar. At 7:00 ET, CPI for January is anticipated to contract for the fourth straight month at a rate of 0.3 percent while the annualized pace is forecasted to slip to a 2-year low of 1.1 percent. Meanwhile, the BoC’s core CPI measure may actually hold relatively high at 2.2 percent, though this would be down from a 1.5 year high of 2.4 percent. Given the sharp drop in commodity prices since the summer and slowing in the Canadian economy, there is potential for weaker-than-expected readings and thus, the Canadian dollar could pull back further. On the flip side, stronger than expected results could lead to increased speculation that the BoC is done cutting rates and subsequently drive the currency higher.

Terri Belkas is a Currency Strategist at FXCM.