Dollar Unfazed by Weak Retail Sales: What’s Going On?
US consumer spending dropped by the largest amount in two years, yet the dollar only weakened modestly. As the backbone of the US economy, the level of spending is generally seen as a reflection of not only how the US economy is doing presently, but also how it could perform in the months to come. Therefore the 0.9 percent drop in retail sales should have elicited a big reaction in the currency market, especially since sales excluding autos also declined in the month of June. The immediate reaction off of the data was sizeable, but the dollar’s recovery against the Euro and its failure to fall further is a testament to the currency’s resilience as well as the market’s hope that better things are to come. Even though retail sales was weak, import prices, business inventories and the preliminary University Michigan consumer confidence survey all beat expectations. Confidence would not have hit a 6 month high if the economic outlook was that dismal. Consumers expected future economic conditions to improve, which means that their spending levels could rise as well. The dollar has weakened significantly over the past few months. This weakness could drive a second half recovery by boosting manufacturing, exports and tourism. This is the basis for the Federal Reserve’s optimistic growth forecast because they believe that increases in any of these sectors should keep job growth steady, cushioning the economy from a major contraction in growth. Furthermore inflation will be the market’s main focus next week. Not only are consumer and producer prices due for release, but Fed Chairman Ben Bernanke will also be delivering his semiannual testimony on the economy and monetary policy. With oil prices solidly above $70 a barrel and rising, Bernanke will need to continue to stress the upside inflation risks which will help the US dollar.

Iran’s Asks Japan to Pay for Oil in Yen, Putting a Dent into Carry Trades
The Japanese Yen rebounded today following news that Iran wants Japan to start paying for its oil in Yen. This announcement is more important symbolically than economically because Japan only imports $10 billion worth of oil per year. In a market that trades over $2 trillion a day, this should hardly put a dent into the market’s overall demand for Yen. Furthermore, Iran is running out of oil, having only recently imposed fuel rations. Symbolically this is important however because it shows that many nations are concerned about the imported inflation that the weakness of the dollar has brought to their own countries. Just yesterday, Kuwait announced that it was going to allow the dinar to appreciate by 0.4 percent in order to lower inflationary pressures. Surprises like these are the only things that have the potential to drive the Yen higher these days. BoJ Governor Fukui’s failure to signal an August rate hike has kept carry trades steady. Japanese markets are closed on Monday. The economic calendar is extremely light in the week ahead.

Euro Hits New All-Time Highs Before Retracing
The Euro hit a new all-time high of 1.3813 following the release of the ECB monthly bulletin, which confirmed to the market that inflation risks were to the upside and monetary policy remained accommodative. Despite the weaker US consumer spending numbers, the rebound in the dollar suggests that the rally in the Euro is becoming exhaustive. Even though ECB officials have remained relatively quiet about the EUR/USD’s movement, the higher the Euro rises, the greater the risk that ECB officials will become concerned. Previous tops in the currency pair have been triggered by cautionary comments from ECB President Trichet and there is no reason why this couldn’t happen again. French consumer prices fell short of expectations, but excluding tobacco prices, consumer prices were higher than expected. Eurozone consumer prices and the German ZEW survey of analyst sentiment are the only potentially market moving releases in the week ahead. Switzerland has retail sales and the trade balance, which could help drive gains in the Swiss Franc.

Big Week Ahead for the British Pound
The British pound took another shot at its recently set 26 year high against the US dollar today thanks to hawkish comments from the Bank of England and stronger economic data. Both consumer spending and the housing market continues to remain steady with the Financial Times house price survey reporting a 0.7 percent rise in house prices in the month of June. This helps to alleviate any concerns that may have come from the 18 month low hit by the RICS house price survey reported yesterday. Department store sales at retailer John Lewis increased 11.7 percent year over year last week thanks to clearance sales. This economic stability has allowed the Bank of England to focus almost exclusively on inflationary pressures, which continue to be a growing concern. BoE Chief Economist Bean warned today that the swings in actual inflation could “lead to inflation expectations becoming less well-anchored” and that it was extremely important for the central bank to keep inflation expectations anchored. In the week ahead, the British pound will be in play with a very busy economic calendar that includes inflation data, employment numbers, the minutes from the latest monetary policy meeting and retail sales.

Australian Dollar Hits 18-Year High, Inflation Up Next for Commodity Currencies
The Australian dollar rallied for the sixth consecutive trading day and hit a new 18 year high despite the lack of any economic data. This suggests that the market’s risk seeking appetite remains strong, especially since AUD/JPY also hit a new high. Unlike the Australian dollar, the New Zealand dollar accelerated due to the combination of stronger New Zealand retail sales and weaker US retail sales. This divergence could lead to more gains in the NZD/USD. The Canadian dollar continues to hover near its 30 year highs following the hawkish statement earlier this week. Looking ahead, inflation will be the focus for all three commodity currencies.

Kathy Lien is the Chief Currency Strategist at FXCM.