Dollar on a Roll
Still mostly green for the greenback as economic data continued to impress with New Housing printing a surprisingly strong 4.8% jump while Durable Goods ex-transport beat expectations by a factor of four registering a gain of 2.4% versus 0.5% forecast. The economic news demonstrated the resiliency of theUS economy with the data taking many dollar bears by surprise as the projections of a housing led slowdown were clearly off the mark. Talk of any Fed rate cuts was completely erased from traders’ minds, and instead the focus was on the possible resurgence of tightening policy from the Fed. Terri Belkas’s mid week report focused on the incoming new voting members of the FOMC most of who expressed rather hawkish views on the economy. Little wonder then that by the end of the week with long term rates inching to 6 month highs, the dollar was trading near two month highs against the euro.

Next week the calendar contains one of the busiest schedules of the year with FOMC, ISM and NFP all on the docket. The fed is of course expected to stay pat, but the market will examine the language of the communiqué very carefully and if there is any hint of a hawkish bias the greenback may get a further boost as traders consider the notion that US monetary policy makers may not be finished with the rate hikes just yet. Following FOMC, comes the monthly ISM data which is expected to show a marginal decline but remain above the critical boom/bust level. Finally the week ends with NFPs – an although the report is expected to print mildly lower than the month before, as long as it stays near the 150K level the downside risk to the dollar should be minimal. All in all a very busy week that could explode in volatility if we hit some surprises.

Euro Has VAT on Its Mind
Fear of the VAT tax dominated economic news from the Eurozone this week. The rise in value added tax from 16% to 19% affected both consumers and producers as GFK Consumer sentiment pulled back sharply from 8.4 to 4.8 while the all important IFO ticked lower to 107.9 from 109 expected. Clearly, both parties viewed the prospect of higher taxes with trepidation, and as we noted on Thursday, “The issue could become a huge albatross for the Merkel administration if it suddenly chills economic activity in Germany just as the country is finally generating some growth momentum. However, the key determinant of success or failure may lie outside the reach of either businesspeople or politicians. If the price of oil remains below $60/bbl providing a benign environment for EZ consumers, the increase in VAT taxes may indeed be absorbed with minimal pain. If on the other hand, oil begins to rally in the summer season, the double whammy of higher taxes and higher energy costs will almost certainly stifle any recovery in EZ consumer demand.”

For now the currency market has shrugged off the news believing that it will have only a small negative effect on growth and will not prevent the ECB from hiking rates further. But if next week retail sales shows signs of additional deterioration, traders will have to reassess their nonchalant attitude and consider seriously the possibility of a nasty slowdown in the Euro-zone as a result of these policy choices.. IN addition to retail sales German unemployment numbers and EZ Manufacturing PMI are all on tap as well and could push trade either way although market expectations are for relatively little change from the month prior. Overall the data fest from both US and EZ could have substantial impact on price of the pair especially given the fact that EURUSD is approaching key support zone. The answer to whether this anti –dollar rally continues or a new dollar up trend is in place may well be revealed by end of the week.

Yen – Still Victim to the Carry
On Friday we wrote, “Yen lost whatever strength it gathered over the past two days after Japanese core CPI printed at 0.1% versus 0.2% expected. The news sparked the return of the carry traders and sent USDJPY once again above the 121.00 figure to within 10 points of the week’s high. At present , USDJPY remains a hopeless victim to the carry, as Japanese economic data refuses to provide any meaningful support for yen bulls However, despite today’s tepid inflation numbers the fact of the matter is that core inflation registered its first positive reading in this decade and if that price momentum continues, real interest rates will become negative – a scenario the BoJ will assuredly wish to avoid. In that context Ms. Suda’s observation yesterday, that BoJ needs to be more pro-active regardless of immediate economic results should serve as warning to the multitude of yen shorts. The level of complacency in that trade has reached extremes and while USDJPY can certainly push higher still, the likelihood of a sharp correction grows stronger every day.”

Looking at next week’s calendar, the front of the week provides little reason for hope to yen longs as Retail data, Overall household spending and Industrial Production are all expected to produce worse results than the month prior. If there is any solace to be found at all it lies in the fact that despite the persistently negative news the yen has essentially stopped going down against the greenback. The currency lost a marginal 25bp against the dollar this week posting the second best performance after the kiwi. Any upside surprise therefore may trigger a wave of carry trade liquidation outing the 120 level back in the sights of carry longs. However, if the news continues to be as unsupportive as it has been, the 122.00 barrier is just within reach and once it breaks momentum may take the pair even higher. At this critical pivot point, it appears that yen traders are perhaps the most data dependent lot in the currency market.

Pound Plunges on Split BOE
Just over a week ago, traders perceived the Bank of England as holding a staunchly hawkish stance, as money supply and inflation growth continued to accelerate. However, a split amongst the monetary policy committee and a plunge in mortgage approvals left Cable to drop more than 300 points throughout the week. The biggest surprise of the week came in the form of the BOE meeting minutes, which showed the unexpected decision to hike rates this month was a close 5-4 vote. The dissenters noted that there was insufficient cause to warrant a tightening of monetary policy in January, citing that inflation is likely to fall back later in 2007. However, the release of stronger-than-estimated Q4 GDP of 3.0 percent underpinned the BOE’s pre-emptive decision. Data released later in the week made it far more likely that the UK’s central bank will leave rates on hold for the remainder of Q1, as the British Bankers’ Association reported that mortgage approvals plummeted 41 percent in December from the month prior. While further evidence of a weaker housing sector will be needed to confirm this steep drop, the BBA report certainly diminished expectations even further for additionally tightening in monetary policy.

Traders will be able to weigh the results of other economic indicators out of the UK next week which will likely leave Cable highly vulnerable, as the markets may see more evidence that the housing sector is slowing on the BOE’s aggressive monetary policy action over the past six months. Nationwide house prices and net mortgage lending are both anticipated to decline. Additionally, retail and sentiment reports are expected to show that consumers are a bit more pessimistic in the New Year. Should the data fall in line with expectations, markets may stop pricing in a February hike to 5.50% and open the gates for GBP/USD to plunge below 1.9500. However, a pickup in M4 money supply could override doubt in the housing sector, as the BOE has cited M4 as a major reason for vigilance in monetary policy, creating upside potential for Pound.

Swissie Slides on Stagnant Prices
The Swiss franc edged lower against the greenback last week as inflation growth remained mild. Producer and import prices stagnated in December, leaving the annual rate to decelerate to 2.6 percent from 2.8 percent as a result of continued weakness in oil prices. The data isn’t exactly surprising, however, as the Swiss National Bank’s outlook for 2007 inflation is set at a paltry 0.4 percent. Meanwhile, the UBS consumption index increased from 1.889 to 1.896 in the month of December, supporting the optimistic growth prospects noted by SNB President Jean-Pierre Roth. Although the SNB’s bias is still on the hawkish side, Swissie remains the victim of the carry trade and will likely remain so until price pressures pick up markedly and increase the potential for more aggressive monetary policy.

Swiss event risk next week will do little to help the national currency, as the most important economic gauge for the country, the KOF leading indicator, is expected to dip to a one year low of 1.54. The other marquee event comes a day later at 14:25GMT, when SNB President Roth speaks. His commentary will likely give Swissie at least a brief boost as he commonly mentions that the central bank plans on normalizing interest rates so long as economic data falls in line with expectations. Additionally, the trade surplus is estimated to narrow significantly to 0.80 billion francs, indicating that demand for Swiss products may be weakening. However, the import balance will be of significant interest, as buoyant consumer spending, albeit of foreign products, points to solid domestic demand and is a positive sign of growth within the country.

Loonie Lifeless After Lackluster CPI
The Canadian dollar weakened further last week as signs emerged that inflation risks were lessening. The Bank of Canada’s core measure of CPI surprisingly dropped to 2.0 percent – in line with the Bank’s inflation target. However, BOC Governor David Doge said that the lower-than-expected core inflation rate doesn't alter the central bank's view, because it looks at longer trends, which kept Loonie from racking up more substantial losses. Additionally, Mr. Dodge warned that consumer spending and home prices may cause inflation to surge past the central bank’s target but that slower growth in the US may ease inflationary pressures. Mr. Dodge also noted that both risks are smaller than they were in October. Nevertheless, slowing retail sales growth and a disappointing leading indicator figure appeared to cement the prospect that the BOC will leave rates on hold throughout the first half of 2007.

Canada’s economic calendar next week has the potential to give Loonie a boost, as demand for products out of the manufacturing sector are anticipated to improve, despite a slowing in the US economy. Additionally, a pickup in the industrial product price index may signal that price pressures are mounting at the factory gate, which could lead inflation to accelerate back above the BOC’s 2.0 percent target. The last piece of data out of Canada comes on Wednesday morning, when GDP during the month of November is expected to have risen 0.3 percent. Overall, the indicators for the week should highlight the upside risks to growth and inflation that Governor Dodge mentioned last week, which may help keep USD/CAD sub-1.1800.

Aussie Inflation Disappoints, Sends AUD Through Support
The Australian dollar was the biggest loser last week, as a soft inflation report was enough to push the currency significantly weaker against major counterparts. Expected to print at a modest 0.2 percent quarter-over-quarter gain, the headline number actually fell for the first time in nearly eight years—putting a halt to any monetary policy tightening through the medium term. Subsequent expectations of stable Reserve Bank of Australia rates through the first quarter left the Aussie considerably weaker, while technicals hinted at the potential for further declines. The coming week’s economic data is unlikely to produce any fundamental-based demand, as a bearish forecast on closely-watched Trade Balance figures could put downward pressure on the Aussie.

Upcoming data may look to disappoint, with tepid second-tier data to be followed by a similarly lackluster Trade Balance release. Inflation watchers may pay close attention to early Private Sector Credit news, with a likely moderation to point to less private borrowing for the domestic economy. Otherwise, analysts and traders will closely monitor Thursday night/Friday morning’s Trade Balance report for unexpected results. Economists cite significant risks to the downside on consensus estimates, as a persistent drought has put a sever limit on agricultural exports. Unless the numbers surprise the consensus view , we could see a material Australian Dollar decline on a widened trade deficit.

RBNZ Hawkishness Weathers All Ills
If the Reserve Bank of New Zealand was ever expected to change its position on monetary policy, last week’s meeting was probably the best chance in over a year. A little more than a week before the event, quarterly consumer inflation numbers suggested the long awaited turn towards dovishness was at hand. Through the fourth quarter, the average price for goods in the consumer basket dropped 0.2 percent, matching the biggest contraction the indicator has reported in over seven years. With inflation falling back to manageable levels, many market participants believed the central bank would finally be able to turn its attention to the struggling economy. However, when Governor Alan Bollard took the podium, he reiterated his concern for housing and domestic demand-driven inflation and stated that without clear pullback in these areas in the economy, “it is likely that further policy tightening will be required.”

For the week ahead, RBNZ’s comments will still hold sway over the kiwi. Now every indicator to come out of the country will be read in terms of how it could possibly change monetary policy makers’ perception of the essential mix of economic activity and price growth. One indicator that will hold a direct correlation to these concerns is December building permits. Filings for construction have dropped in the two previous months; and though it is a volatile read, a third contraction would offer strong evidence that consumers are less enthusiastic about taking on the hefty financial burden. The other indicator to keep an eye on is the Trade balance for the same month. With little hope for a rate hike on the horizon, New Zealand will be left to fend for itself. A strong performance from exports may just be the medicine to pick up the other sectors the ailing sectors of the economy. With all of this in mind though, the possibility of yet another rate hike for the currency with the second highest benchmark lending rate among in the OECD will help to solidify its appeal as the preferred long-side to the carry trades.

Boris Schlossberg is a Senior Currency Strategist at FXCM.