US Dollar, Japanese Yen Down as CPI Shows the US is Teetering on Brink of Deflation

The US dollar and Japanese yen ended Friday mostly lower despite clear signs of risk aversion as evidenced by gold's test of $1000/oz, sharp drops in global stock markets, and a rally in government bonds, including US Treasuries. However, with the majors generally still contained to ranges and near their spike highs/lows, it may be a bit early to say that the US dollar and Japanese yen have lost their status as “safe havens,” as correlations have a tendency to fade in and out over time. Looking at charts of the DXY Index, price pulled back from resistance at the 2008 highs and the outlook for the greenback for the next few weeks may hinge upon whether or not the drop signal a reversal or ultimately yields a break higher.

On Thursday we noted that surprisingly strong producer price growth suggested that consumer price growth would be similarly high. This proved to be the case on Friday morning as the US consumer price index (CPI) unexpectedly rose 0.3 percent in January, while the core index, which excludes volatile food and energy costs, rose 0.2 percent. The more important factor though, was that these moves helped to prevent the annualized CPI reading from falling into negative territory for the first time since 1955. Instead, the figure eased to 0 percent, signaling that prices have essentially gone unchanged from January 2007, while the core figure stayed afloat at 1.7 percent, down from 1.8 percent in December. It appears that producers aren’t passing on lower input costs to consumers, as they struggle to maintain profits as demand falters, but with CPI still historically low, the Federal Reserve is highly unlikely to be concerned about upside risks to inflation, as contracting demand and credit creates greater risks for deflation.

Looking ahead to next week there will be a handful of events that US dollar traders will need to watch. On February 24 at 10:00 ET, the Conference Board’s consumer confidence index for the month of February is forecasted to reach a fresh record low of 36.0, down from 37.7. With record keeping having begun in 1967, the plunge in sentiment makes the extent of the recession even more clear. However, with Federal Reserve Chairman Ben Bernanke due to testify before the Senate on the economic and Fed policy at the same time, the consumer confidence result may have little impact on the markets. Instead, traders will be listening closely for more detailed outlooks on growth, unemployment, inflation, and the financial markets. Bearish commentary could weigh heavily on risk appetite, and as a result it will be important to keep an eye on the link between the currency markets and stocks, as the Japanese yen hasn’t been responding as strongly to shifts in equities while the US dollar still tends to benefit from flight-to-quality. On February 26 at 8:30 ET, signs that domestic demand is showing no sign of recovery should continue to emerge on February 26 as US Durable Goods Orders are forecasted to have dropped 2.3 percent and even excluding transportation is anticipated to fall 2.0 percent. Finally, on February 27, the 08:30 ET preliminary reading of Q4 GDP for the US is forecasted to be revised even lower after initial estimates showed the index down 3.5 percent. The latest results may show a sharp 5.4 percent contraction, which would still be the worst since Q1 1982.

Euro Jumps as ECB’s Nowotny Says Zero Rates ‘Neither Desirable Nor Needed’

The euro jumped during the US trading session as European Central Bank Governing Council member Ewald Nowotny said that cutting interest rates down to zero was “neither desirable nor needed,” suggesting that the ECB’s dovish bias may be fading quickly. However, the markets are still expecting a 50 basis point cut by the ECB on March 5, as various other ECB members have signaled such a move in recent weeks. Furthermore, data continues to disappoint as the composite Purchasing Managers' Index (PMI) for the Euro-zone's manufacturing and services sectors unexpectedly fell to a new record low in February or 36.2 from 38.3, which also signals a contraction in activity for the ninth straight month since the index remains below 50. Looking ahead to next week, Eurostat inflation estimates for the Euro-zone have shown that CPI may have fallen to a 1.1 percent annual pace during January, which would mark the lowest since 1999 but more importantly, remains below the European Central Bank’s 2.0 percent inflation target. If Eurostat confirms this at 5:00 ET on February 27, the euro could pull back, especially ahead of the ECB's meeting the following week. On the other hand, if CPI is higher than anticipated, the currency could gain as the markets will speculate that the central bank may pause in their efforts to make monetary policy more accommodative.

British Pound Gains as UK Retail Sales Rise, UK GDP Revision Could Weigh Next Week

The British pound gained on Friday after UK retail sales figures showed another rise in spending during the month of January amidst heavy discounting. However, the BOE said a few months ago 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. Next week on February 25, the 04:30 ET preliminary reading of Q4 GDP for the UK is forecasted to revised even lower, down to -1.6 percent from -1.5 percent, which would still mark the lowest level since Q2 1980. 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 Bank of England will cut rates again on March 5. On the other hand, if GDP is a bit better than forecasts, the currency could gain.

Canadian Dollar Shows Little Reaction to Bigger Than Expected Drop in Canadian CPI

The Canadian dollar showed a relatively muted reaction to inflation figures, despite the fact CPI fell more than expected, as sharp declines in the US dollar across the majors determined price action for the USD/CAD pair. Taking a closer look at the data, CPI slumped for the fourth straight month in January at a rate of 0.3 percent, bringing the annual rate down to match the two-year low of 1.1 percent. Meanwhile, the Bank of Canada’s core measure slipped another 0.4 percent, dragging the annual rate down to 1.9 percent from 2.4 percent. Overall, weaker commodity prices are dragging broader prices lower, but as we discussed yesterday, cheaper oil has extremely negative repercussions for the Canadian economy as a whole.

Terri Belkas is a Currency Strategist at FXCM.