As U.S. Surprises, Focus Turns To China

With the U.S. dollar trading higher against all of the major currencies except for the Japanese Yen, it is clear that risk aversion is still the main theme in the financial markets. U.S. stocks ended the day lower as the S&P 500 dropped to a three-month low. Concerns about the U.S. and Euro-zone economies never escape us but with the U.S. Presidential Election and the European Central Bank meeting over, the focus of the FX market over the next 24 hours will be on China.

This is a big week for China in more ways than one. The Communist Party is in the process of holding its 18th Party Congress and this high profile event will continue into next week culminating with the introduction of the country's newest leaders. Speaking before thousands of members of the party, President Hu Jintao dashed hopes for major political reform. He reminded his nation and the world for that matter that China is under a one party rule and there will be no change to state dominance under the new leadership. However political reform isn't what concerns the world and the financial market right now. Instead, we focus more on the party's plans for a more market based currency and interest rate and ambitious goal doubling per capita over the next 10 years. The government's continued focus on the economy and commitment to supporting growth should provide a boost to equities but between the U.S. election and the ECB's warning of slower growth in Germany, this message has been lost.

Yet the performance and outlook for the Chinese economy cannot be ignored with inflation, industrial production and retail sales scheduled for release Thursday night. Inflationary pressures are expected to remain muted so the focus will be on industrial production and retail sales. With the stabilization in manufacturing and service sector activity, further improvements are expected in production and spending, which should lend support to risk appetite and more specifically, help the Australian dollar hold onto its gains.

Meanwhile better than expected U.S. data helped to stem the bleeding but failed to reverse the losses. According to the latest jobless claims report, the labor market improved because weekly claims fell to 355K from 363K. Continuing clams also dropped to 3.12M from 3.262M. Next week we expect to see a big improvement in claims due to Hurricane Sandy, which shut government offices in the Northeast and prevented people from filing their unemployment benefits. Even if the data is distorted, we continue to see improvements in the labor market. The U.S. trade deficit also narrowed to -$41.54B in the month of September from -$43.79B. Imports increased but thanks to record-breaking exports, the U.S. trade gap narrowed to its smallest level since December 2010. This improvement is encouraging but was largely attributed to higher fuel and soybean prices. The trade gap with China continued to grow but based on the sharp improvement in the trade deficit with Europe, demand from the Euro zone fell significantly in the month of September.

EUR: ECB Content But Greece And Spain Still A Problem
ECB President Draghi's post monetary policy meeting press conference was also a big focus today and there was a dour tone in his voice as he talked about their expectations for weak growth into 2013. The ECB does not see any major improvements in growth next year and as a result, inflation should remain subdued and won't be a problem for the central bank in 2013 because inflation is expected to fall below their 2% target. Draghi also said they have not discussed further actions for next year and even though no one has tapped OMT, its availability as an option has been enough to improve financial market confidence. In other words, the European Central Bank is worried about growth next year but content with the current level of monetary policy into yearend. However, the rally in the euro was capped by images of yesterday's riots in Greece. The country is in a very tough bind. Greece made a deal with the devil -- they infuriated their citizens by approving the austerity package to get access to their next aid payment and EU Ministers are now saying that they plan to delay a decision on Greece for weeks. This runs right up against their end of month deadline at which time the Prime Minister says they will have effectively run out of money. ECB President Draghi threw up his hands and said they are by and large done with Greece and all they care about is Spain but Spain refuses to accept a bailout. Spanish 10-year bond yields rose to a six-week high today, confirming that Spain remains a source of uncertainty for the Euro zone and the euro. The trade balance in Germany and France improved in the month of September, but a decline in exports and imports in Germany reinforces ECB President Draghi's concern for the German economy.

GBP: No Changes From BoE
The British pound ended the day unchanged against the U.S. dollar after the Bank of England left monetary policy steady. Interest rates in the U.K. remain at 0.5% and the asset purchase program at 375 billion pounds. The decision and lack of reaction in the British pound was not a major surprise but given recent economic reports, we think the minutes from this meeting, which will be released in two-weeks' time will show more willingness to ease monetary policy. There is a lot of resistance against providing further stimulus within the central bank and even if the minutes have a more dovish bent, the Bank of England may not find enough consensus to ease before the end of the year. Next week's Quarterly Inflation report will provide an indication of how worried policymakers are about the outlook for the U.K. economy. In the meantime, trade numbers are due for release tomorrow. The U.K. trade deficit is expected to narrow but with the manufacturing PMI index falling and particular weakness seen in new orders, we think there is room for a downside surprise hat could lead to weakness in the British pound.

AUD/NZD Closing In On Two-Month High
Even the countries down under are beginning to see a sharp divergence in economic performance, leading to a divergence in currency activity. The Australian dollar rebounded against the U.S. dollar while the New Zealand dollar extended its losses. As a result, AUD/NZD soared for the fourth consecutive trading day to its highest level in nearly two months. Today's price action reflects a continued shift in positioning after last night's surprisingly large increase in New Zealand's unemployment rate. Labor market conditions in New Zealand deteriorated dramatically as the country's unemployment rate rose to its highest level in 13 years in the third quarter. The RBNZ will have no choice but to cut interest rates at their next monetary policy meeting and if they don't, the market will question the new central bank governor's priorities and resolve. If AUD/NZD clears 1.2810, it could be on its way to 1.30. Unfortunately better than expected trade numbers failed to lend support to the Canadian dollar. Canada's trade deficit shrank to -0.83B from -1.52B. The lack of enthusiasm stems from the details of the report, which showed no change in imports and a 1.9% increase in exports caused almost entirely by higher energy prices. The loonie also shrugged off a 0.2% increase in house prices due in part to a drop in housing starts. Despite the narrower trade gap, we still believe that the Bank of Canada will retract their bias to raise interest rates at their next monetary policy meeting.

JPY: First Current Account Deficit In 30 Years
The Japanese Yen traded higher against all of the major currencies despite a major disappointment in economic data. For the first time in more than 30 years, Japan reported an adjusted current account deficit. In the month of September, Japan's current balance dropped from a surplus of Y722.3 billion to a deficit of -Y142 billion. While Japan has been running a trade deficit since March of 2011, dividend and interest income from Japanese investments abroad more than covered the balance. Last month however the trade deficit widened so significantly that the 1.22 trillion income surplus failed to offset the decline. With yields on investments abroad shrinking, current account deficits could become a norm for Japan, which would be a big problem for the Japanese Yen. Yet it is clear from today's price action that even though more money is flowing out of Japan than coming in, investors have not stopped buying the Yen. Safe haven demand continues to drive the Yen higher but if current account deficits become a norm, the yen could start to lose this status.

Kathy Lien, Managing Director of FX Strategy for BK Asset Management