• Biggest Two Day Move in EUR/USD in Five Years
• German Retail Sales Expected to be Weak
• More Confusion: UK Consumers Cut Credit Borrowing, but Mortgage Lending Remain Strong

US Dollar
Yesterday we posed the question of whether the strong dollar sell-off in the first trading day of the year would be indicative of a new trend for the dollar and today, the extension of the move builds an even stronger case that 2006 could very well be the year for EUR/USD bulls.  The 320 pip rally in the Euro is the biggest two day move in five years.  The Wall Street Journal is carrying an article by renowned Fed Watcher Ip, who sees only one or two more rate hikes before a pause.  Today, the Euro easily cleared the 1.21 level against the dollar as we look to the increasing possibility of an end to the Fed's aggressive tightening cycle in 2005.  Today, the MBA mortgage application index registered a seventh decline in nine weeks suggesting that housing growth which has been the cornerstone of US economic expansion may be finally losing steam. The Fed sees these signs as well and yesterday's language which included the sentence "the number of required rate hikes needed to control inflation probably would not be large" was universally interpreted as being dovish.  They realize that with over $2.5 trillion worth of adjustable rate mortgages that are due to reset to market prices over the next 2 years, homeowners may be facing more difficult times ahead.  Right now, they are being shielded by extremely low long term yields, so the exact extent of the damage is still unknown.  According to Fannie Mae, even though only 10 percent of conventional loans are set to reset in 2006-2007, an alarming two thirds of their sub-prime loans which are at a higher risk of default will be resetting.  This means that a $678 monthly payment on a $200,000 loan could balloon to anywhere from $958-$1661. Therefore the Fed has to be very careful with its next step. Since the dollar rally was based on ever expanding interest rate differentials with the Euro, yesterday's FOMC notes have set the tone for trading in the greenback.  In all likelihood, the next meeting will be accompanied by yet another neutral statement that gives the new Fed Chairman full flexibility to make any decision without seeming to diverge too significantly from Greenspan's methodology.  Meanwhile factory orders came in slightly stronger than expected, rising 2.5 percent in November, but the 0.5 percent downward revision to the previous month's report offset any possible bullishness. 

Euro
With nothing expect inflation estimates on the calendar, the Euro extended its previous day's gains.  The Eurozone's consumer price inflation estimate for the month of December fell from 2.3 percent to 2.2 percent while the preliminary releases of Italian inflation also ticked lower.  Inflation seems to have receded globally last month as Switzerland joined in by seeing its own consumer prices dip for the second month in a row by 0.1 percent.  Despite the slide, the ECB still believes that inflation will increase this year, which will keep their hawkish bias intact.  Last year, the EUR/USD sold off in anticipation that the Fed would be very aggressive while the ECB stood with its hands tied around its back as they balanced higher inflation with weaker data.  This year, the anticipation that the Fed is almost done raising rates and the ECB is just beginning to increase rates will be a macro driver for price action in early 2006.  Unsurprisingly, there are rumors that tomorrow's Germany retail sales numbers could be very bad.  It is unsurprising because German data is one of the few that gets leaked rather frequently.  According to a report by Market News, retail sales may have fallen as much as 1.0 percent in November, compared to the market's forecast for 0.1 percent growth.  Since part of the Euro's rally has been based on stronger Eurozone data, the weaker report could result in a shallow retracement in the EUR/USD.

British Pound
Much like yesterday, the British pound screamed higher thanks to broad dollar weakness.  Data from the UK was mixed with a tinge of weakness in the more current data.  Construction sector PMI for the month of December fell from 54.2 to 52.6, which contrasts with the markets expectation for a rebound to 54.8 and eliminates the previous month increase.  Consumer credit for the month of November fell to GBP 0.9 billion from GBP 1.2 billion, the weakest reading since December 2000.  Slowing consumer credit could be indicative of more cautious spending, which could filter into weaker spending during the holiday season.  Mortgage lending however jumped from GBP 7.7 billion to GBP 8.7 billion, which is the highest reading since July 2004.  The blockbuster report suggests that the housing market may be reviving after a year long slowdown.  Finally, money supply growth increased by 1.1 percent in November, which translates into an annualized growth of 12.1 percent, the fastest pace of growth in 15 years. 

Japanese Yen
Even though the dollar extended yesterday's gains against the Japanese Yen, the Yen lost value rather significantly against all of the other majors.  This goes to show that sentiment in the Yen may not be as bullish as the price action in USD/JPY may suggest.  There is word that foreign investment out of Japan is fueling some of the Yen weakness.  With no near term policy tightening in sight, it does not surprise us to see some flight of capital to more higher yielding opportunities.  Despite the dollar's carry advantage, the USD/JPY carry trade may be overdone and coming to an end sooner rather than later which makes an exodus out of that trade a higher priority than one into it.  No data is expected from Japan until Friday which means that until then, the other currencies will continue to dictate the Yen's valuation. 

Kathy Lien is the Chief Currency Strategist at FXCM.