Japanese Yen Outpaces Safe Haven US Dollar as Q4 GDP Falls 6.2%, S&P 500 Closes at Lowest Level Since 1996

Flight to quality resumed on Friday, leading the US dollar to gain against nearly every currency as the S&P 500 fell to its lowest closing level since December 1996. The surprising thing was that the Japanese yen was actually the bigger beneficiary of risk aversion, suggesting that the currency may not have lost its “safe haven” status. It is worth noting, though, that the Japanese yen still ended the week down sharply against the majors, so traders should be wary of depending on the currency’s fading link with risk trends.

These moves started early as the US government has moved ahead with their "stress test" assessment of Citigroup, and has decided to convert up to $25 billion worth of preferred shares into common shares. Furthermore, Citigroup agreed to restructure its board of directors so that a majority of the members are new and independent. This is slowly bearing some resemblance to Sweden's nationalization efforts in the early 1990's, but as we noted in our special report, the plan may be too piecemeal to be truly effective. The other issue high on the mind of investors was the downward revision to US GDP. Indeed, growth in Q4 was revised down to -6.2 percent from -3.8 percent, which still remains just above the Q1 1982 low of -6.4 percent. A further breakdown of the Commerce Department’s summary shows that revisions to personal consumption were responsible for much of the decline, as spending fell 4.3 percent versus previous estimates of a 3.5 percent drop. Meanwhile, gross private investment was revised down to -20.8 percent from -12.3 percent thanks to dismal nonresidential and residential investment, suggesting that the commercial property market is taking a heavy hit. Finally, exports were revised down to -23.6 percent from -19.7 percent, and while the US isn’t nearly as dependent upon trade for growth as countries like Japan, the results indicate the conditions remain tough for American manufacturers.

On Sunday at 20:30 ET, Japanese labor cash earnings are forecasted to remain exceptionally low at -1.2 percent in January from a year earlier, marking the third straight month of negative results. Japanese consumption has been very low for a long time, as there was little to no wage growth to provide an increase in discretionary income. When you consider that labor earnings have recently been steadily declining, it becomes clear that there is almost no impetus for households to spend and support the economy.

Looking ahead to Monday, 8:30 ET economic releases from the US are expected to show that personal income growth contracted 0.2 percent in January, while spending may have actually increased 0.4 percent. This would be in line with the surprise increase in Advance Retail Sales for the same period, but may simply reflect an increase in prices following the heavy discounting implemented in December for the holiday shopping season. The 10:00 ET release of the ISM Manufacturing index, however, will give a more timely view of conditions in the economy. The index is anticipated to fall toward the nearly 29-year lows of 32.9 to 34.0 in February from 35.6. This would mark the thirteenth straight month of contraction in business activity, suggesting that the recession could continue throughout 2009. Weaker than expected results could lead flight-to-safety to push the US dollar higher, while surprisingly strong numbers could weigh the currency down.

Euro Under Pressure as Drop in CPI Suggests ECB Will Cut Rates to 1.50% Next Thursday

The euro slumped throughout much of Friday, breaking below immediate support at 1.2690, as Euro-zone CPI slowed in line with expectations to an annual rate of 1.1 percent, the lowest since 1999. On a longer-term basis, resistance looms at 1.3000 while support rests at 1.2500, and either of these levels could be tested next week as the European Central Bank (ECB) will announce their next rate decision on March 5. The decline in Euro-zone CPI estimates well below the ECB’s 2.0 percent target, steady increases in unemployment, and increasingly pessimistic consumer and business confidence all suggest that the central bank will cut rates by 50 basis points to 1.50 percent. Indeed, after the ECB cut rates to a record low of 2.00 percent on January 15, ECB President Jean-Claude Trichet said that the next "important" meeting would be in March when they release new projections for growth and inflation. Furthermore, he refused to call 2 percent the lower limit for interest rates, leaving the door open to further reductions in coming months. As a result, the 7:45 ET announcement will garner quite a bit of attention, but traders should also look to Trichet’s post-meeting press conference at 8:30 ET. 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 signals that they may leave rates unchanged during their next meeting, the currency could actually rally.

Australian Dollar Falls to Key Trendline Support Ahead of Pivotal RBA Rate Decision

Signs of risk aversion in the markets weighed on the commodity dollar, including the Australian dollar. Focusing on AUD/USD, declines in the pair took price down for a test of a rising trendline that connects the October, November, and February lows. Where AUD/USD goes from there hinges upon both risk trends and the Reserve Bank of Australia upcoming rate decision on Monday at 22:30 ET. Looking to the rate decision, the RBA is anticipated to cut rates in their sixth consecutive meeting, with a Bloomberg News poll of economists calling for a 25 basis point cash rate target reduction to a record low of 3.00 percent. However, only a larger-than-expected rate cut or comments suggesting they will continue to reduce rates aggressively may weigh on the Australian dollar, with signs of neutrality likely to actually boost the currency. Overall, Australia is facing major headwinds from financial market instability, which has led to tighter credit conditions, as well as from both domestic and foreign demand. Indeed, global slowdown is hurting exports, something the Australian economy depends on for employment and broad growth. The situation has not been helped by significantly lower commodity prices, though it has served to cool inflation pressures, which leaves the RBA additional leeway to make monetary policy more accommodative in coming months.

Terri Belkas is a Currency Strategist at FXCM.