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THE STORIES IN THE CURRENCY MARKET

• WILL DOLLAR PULLBACK BE TEMPORARY?
• EUR: STRONGEST RALLY SINCE BEGINNING OF DEC
• GBP/USD: FAILS TO BENEFIT FROM GOOD DATA
• AUD/USD: MANUFACTURING ACTIVITY CONTRACTS
• USD/CAD: LOONIE CLOSES IN ON 2 MONTH HIGHS
• NZD/USD: GOLD AND OIL PRICES RISE
• USD/JPY: EXPORT WOES TO DISSIPATE

EXPECTATIONS FOR UPCOMING FED MEETINGS

CURRENT US INTEREST RATE: 0.25%
	01/27 Meeting	03/16 Meeting
NO CHANGE	62.0%	57.4%
CUT TO 0BP	38.0%	30.6%
INCREASE TO 50BP	0.0%	12.0%
INCREASE TO 75BP	0.0%	0.0%

WILL DOLLAR PULLBACK BE TEMPORARY?

U.S. equities soared to 15 month highs on the first trading day of the New Year.  The rise in stocks, pullback in the U.S. dollar and the demand for high yielding currencies indicates that risk appetite dictated the price action in the foreign exchange market today.  The drivers of the foreign exchange market have been as fickle as the moods of a teenager.  Last month, the U.S. dollar traded primary on U.S. fundamentals but today, the dollar shrugged off positive economic data.  Aside from the British pound, which has been beaten to a pulp, the dollar sold off against every major currency.  It dropped the most against the Australian dollar and the least against the Japanese Yen.

Will the Dollar’s Pullback be Temporary ?

In our opinion, the dollar’s pullback should be temporary.  Not only is January typically a positive month for the U.S. dollar , but if payrolls turn positive like the market expects, the dollar should once again be driven by the outlook for the U.S. economy and not risk appetite.  Last month’s rally in the U.S. dollar was triggered by the much better than expected non-farm payrolls report.  The modest job losses in December accelerated recovery expectations and prompted forex traders to reverse part of their short dollar positions.  If the U.S. economy reports positive job growth for the first time in 2 years, we expect the market to place greater emphasis on fundamentals because once a central bank of a funding currency starts to raise interest rates investors will start reducing their leveraged short positions.  We are still a long way from a rate hike by the Federal Reserve but the currency market moves on expectations and therefore the expectation of positive job growth should help the dollar recover.  Our forecast for non-farm payrolls will be contingent upon the leading indicators for NFPs that are scheduled for release on Wednesday.  Based upon weekly jobless claims alone, the odds favor an improvement in labor market.

Debate on U.S. Growth Prospects Hurts Dollar

However not everyone seems to agree that the outlook for the U.S. economy has brightened.  Nobel Laureate Paul Krugman is particularly pessimistic.  In comments made this morning, he said the unemployment rate will most likely increase, house prices could drop by another 5 to 10 percent while he sees a 30 to 40 percent chance of a double dip recession.  With fiscal stimulus expected to fade by mid-year, additional monetary stimulus may also be needed.  Blackstone’s Byron Wein disagrees and says he sees the unemployment rate dropping below 9 percent.  This divergence in expectations suggests a murky outlook for the U.S. labor market and U.S. economy.  The lack of certainty may be part of the reason why the dollar gave back some of its gains today.  On Sunday, Federal Reserve President Kohn warned that the state of inflation and unemployment warrants low interest rates.  The tone of his speech in Atlanta was very cautious as he indicated that a recovery in growth will probably be gradual and the decline in unemployment will be slow. This afternoon, Fed President Duke said the headwinds in the housing market are relatively strong and household balance sheets remain weak.  However he believes that the recovery will continue at a moderate pace.  

M&A Flows and Economic Data

It is commonly believed that the first five days of trading in the stock market are the best predictor for the year to come.  If this is true and the momentum that we have seen today can be sustained, then we could be looking at a solid year for the equity markets and risk appetite.  If the global economy continues to recover this year, then a recovery in the stock market is not out of the question.  Merger and acquisition flows have started already as well.  Novartis, a Swiss based drug maker has offered to buy the rest of Alcon Inc from Nestle for $39.3 billion.  The easing of the financial crisis and the eventual loosening of credit should help to foster additional M&A transactions.  Pending home sales and factory orders are the only releases on the U.S. calendar tomorrow.  So far, the recovery in the housing and manufacturing sectors has been steady and this leads us to believe that Tuesday’s reports should be relatively positive as well.  In the month of December the ISM manufacturing index climbed to the highest level in more than 3.5 years. The details of the report were mostly encouraging with the new orders and employment components increasing. The increase in manufacturing activity should help to ease job losses in the sector. Despite the strength of the dollar last month, the manufacturing sector continues to chug along. The decline in new export orders suggests that the increase in demand could be domestic, which would be a nice change of pace. Also, the widening of the new orders-inventory gap points to further increases in activity. The significant rise in the prices paid component indicates that inflationary pressures are beginning to return. Although construction spending declined for the seventh month in a row, the pace of contraction is not as significant as the average decline over the past year.

EUR: STRONGEST RALLY SINCE BEGINNING OF DEC

The euro staged its strongest rally against the U.S. dollar since the beginning of December on the heels of positive economic data and an improvement in risk appetite.  The final release of manufacturing sector PMI was revised higher from 51.2 to 51.6 for the month of December thanks to stronger activity in France.  Although the manufacturing index for Germany was revised slightly lower, activity in the sector still expanded at the fastest pace since May 2008.  Investor confidence also improved and if Tuesday’s German employment numbers surprise to the upside, we could see the EUR/USD break its 2 week high of 1.4456.  Greece announced this morning that it plans to cut its budget from 12.7 percent of GDP to 8.7 percent by the end of this year.  Since part of the euro’s underperformance in January was tied to fiscal health of the country, their plans to rein in their deficit should help ease investor concern.  There will be a lot of discussion this week about the precise measures that the country will take to achieve these goals and a final version will be presented to the European Commission at the end of the month.  Meanwhile, according to the PMI reports, job losses in the manufacturing sector moderated while the service sector actually reported positive job growth which suggests that the labor market improved in the month of December.  

GBP/USD: FAILS TO BENEFIT FROM GOOD DATA

Based upon the recent price action of the British pound, one could easily be led to believe that the pound likes to buck the trend. Although it has been a volatile trading day with the pound hitting an intraday high of 1.6241, it ended down against the U.S. dollar.  Economic data was surprisingly positive, leading to expectations that economic growth may have finally turned positive in the fourth quarter of 2009. The Manufacturing Sector PMI shattered expectations by advancing from 52 to 54.1, the strongest in more than two years.  In addition to manufacturing, we saw a host of credit and lending data that indicates consumers are more able and willing to borrow. Mortgage Approvals rose to 60.5K, the highest since early-2008. Furthermore, Net Consumer Credit and Net Lending Secured on Dwellings each exceeded expectations. The improvement in these indicators suggests revitalized consumer confidence and continued strength in the housing market. The Construction Purchasing Managers’ Index will be released during tomorrow’s trading. With the Bank of England’s rate decision on the horizon for Thursday, today’s data made the chances of further easing even more unlikely. However, any true indication of the BoE’s tendencies probably will not be received until the inflation report is released in February.

AUD/USD: MANUFACTURING ACTIVITY CONTRACTS

All the pieces came together today to ensure a powerful rally in each of the commodity currencies. First, there was the strength in Chinese and U.S. manufacturing that added to investors’ risk tolerance. On the back of the euphoria came a rally in oil that saw prices penetrate $81 and the largest jump in gold seen in two months. As a result, the aussie recorded its seventh day of gains, the kiwi broke through to a one-month high, and the loonie briefly touches its highest levels in two-months. However, even though data was light today, the one report that was released was largely ignored by ecstatic traders. The Australian AiG Manufacturing index was a big disappointment, slumping to 48.5 from last month’s 51.2 reading. This was the first time manufacturing activity contracted in five months. AiG noted that this index confirms that Australia’s ongoing recovery remains “patchy.” Patchy is not usually a word used to describe the state of their recovery, which means that the RBA will have even more of a reason to hold rates constant at their next meeting. Furthermore, AiG reported that one of the factors causing the slump was the fact that manufacturing is being dampened by the high levels in the Australian dollar. On tap for tomorrow will be Australia’s HIA New Home Sales. Canada will release their Industrial Product and Raw Materials Price Indices tomorrow as well.

USD/JPY: EXPORT WOES TO DISSIPATE

The only exception to the yen’s weakness was USD/JPY, which broke a four day rally. Otherwise the yen is being hammered across the board, especially against the aussie which has gained for eight days in a row.  While Japan had no data to release today, news coming from China has large implications for their economy. China reported that manufacturing activity expanded by the strongest amount in about five years. This means that Japan is being assured that one of its largest trading partners remains ready and willing to spend on its exports. With the yen starting to lose some strength and the ongoing surge in Chinese activity, Japan may have conquered its exporting fears, for now at least. However, China is quickly starting to become a victim of its own success, as many economists fear that the economy has become overheated. Another factor that helped lift optimism today was news that the situation with Japan Airlines has been temporarily resolved. Signs that the company might have to declare bankruptcy sent USD/JPY on a prolonged rally in the last few weeks. However, it was decided that the Development Bank of Japan would double a credit line that it has with the company. This seems more like temporary relief, one that may come back to haunt the yen if the company struggles further. Data for tomorrow will be limited to the Monetary Base and Vehicle Sales.

EUR/USD: Currency in Play for Next 24 Hours

EUR/USD will be the currency pair in play for tomorrow. From the Euro-zone, we are expecting Germany’s Unemployment rate at 3:55 am ET or 8:55 GMT along with the Euro-zone CPI Estimate at 5:00 am ET or 10:00GMT. The U.S. is scheduled to release Pending Home Sales and Factory Orders at 10:00 am ET or 15:00 GMT.

EUR/USD has posted its strongest rally since the beginning of December, keeping the pair in the Bollinger band range trading zone. For the past 2 weeks, the currency pair has had a very difficult time breaking above 1.4495, the 20-day SMA.  However if the EUR/USD manages to break that level the next area of resistance is not until 1.46.  On the other hand, if the currency pair starts to trickle lower from here, 1.4220, the 200-day SMA will be the key support level.

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About The Author

Kathy Lien began her FX trading career 10 years ago at J.P. Morgan Chase. After graduating New York University’s Leonard Stern School of Business at the age of 18, Kathy joined the bank's interbank FX trading desk and eventually moved to the cross markets proprietary trading desk. In the interbank market, her ability to create solid fundamental and technical analysis from the myriad of information on the market helped her trade forex spot and options. Her experience eventually led her to be chief strategist at Daily FX where she worked until she joined GFT in 2008.

With her knowledge of forex, as well as her experience trading other products, such as interest rate derivates, bonds, equities, and futures, Lien has built a reputation as an international currency analyst. She is frequently quoted on CNBC, Bloomberg, Fox Business and Reuters. Lien has also written for publications like Active Trader, Futures, and SFO magazine. She is the author of the newly updated Day Trading the Currency Market: Technical and Fundamental Strategies to Profit from Market Moves, and the co-author of Millionaire Traders: How Everyday People Are Beating Wall Street at Its Own Game with Boris Schlossberg.

To buy Kathy’s newly updated Day Trading and Swing Trading the Currency Market: Technical and Fundamental Strategies to Profit from Market Moves, click here.