Down To The Wire, Currencies Weaken

At the time of publication, President Obama is still meeting with Congressional Leaders. Some type of announcement is expected after the meeting and if we are lucky, the President will say that he has support from House Speaker John Boehner, House Minority Leader Nancy Pelosi, Senate Majority Leader Harry Reid and Senate Minority Leader Mitch McConnell for a mini-deal that would help the save the country from falling off the Fiscal Cliff. Unfortunately a press conference similar to the one that Obama made last Friday is more likely. If you recall, Obama urged Congress to come back from the holidays with a renewed focus to get a deal done. The President has promised to put forth a new proposal, but that plan would still need to be approved in a vote by the House and Senate. The House is scheduled to convene on Sunday evening and that will be the very last opportunity for a deal to be done before year end. If it becomes evident that a deal will be deferred to January, expect currencies and equities to sell-off in disappointment. With some major currencies pulling back and equities declining, we have already seen investors take profit and hedge their positions ahead of the Fiscal Cliff deadline. If Obama announces a stripped down plan and expresses confidence that a deal will be sealed by end of day Monday, we can expect currencies and equities to rally in relief.

U.S. nonfarm payrolls are due for release next week but the jobs report will be overshadowed by Fiscal Cliff developments, especially at the beginning of the week. Based on the decline in jobless claims, we expect to see non-farm payrolls maintain a steady of pace of growth. Friday's better than expected U.S. economic data failed to lend much support to the greenback. Manufacturing activity in the Chicago region accelerated for the second month in a row as the PMI index increased to 51.6 from 50.4. Unfortunately the details of the report also made the headline number less attractive. Production declined while employment dropped to its lowest level in three years. Pending home sales rose 1.7% in November. While growth slowed since the previous month, the housing market continues to receive support from low interest rates.

Expect a volatile open on Sunday for the FX market, especially with China's HSBC Flash manufacturing PMI report scheduled for release.

EUR: Spanish Prime Minister Warns Of Tough Year Ahead
The euro ended the North American trading session slightly lower against the U.S. dollar. Once again, France was the only major Euro zone nation with economic data Friday and while consumer spending rose 0.2% in the month of November, third quarter GDP growth was revised down to 0.1 from 0.2%. Thursday we learned that higher unemployment in France did not make consumers more pessimistic and Friday we saw that it has not held back spending. Whether this trend is sustainable remains to be seen but for the time being, it is a welcome development for France. Yet comments from Spanish Prime Minister Rajoy renewed some concerns about Spain. In a news conference in Madrid, Rajoy warned of tougher economic conditions and weaker growth for the Eurozone's fourth largest economy in the coming year. He even said he would not rule out asking the ECB to activate its Outright Monetary Transactions program and come into the secondary markets to buy Spanish bonds. With Spanish 10-year bond yields at 5.2%, borrowing costs in Spain are manageable but with the recession expected to continue, more help could be needed. The EUR/USD will be back in focus next week with final Eurozone PMI numbers due for release along with Germany's unemployment, retail sales and consumer price reports.

GBP: Busy Week Ahead For Sterling
Despite the decline in the Dow and the FTSE, the British pound traded higher against the U.S. dollar and euro. It has been an extremely quiet week for sterling. However the action should heat up next week with U.K. PMI numbers scheduled for release. Manufacturing and construction sector activity is expected to continue to contract and it will be interesting to see if the service sector manages to expand. Economists are looking for PMI services to hold steady at 50.2, with 50 being the demarcation between expansion and contraction. However with retail sales growth stagnating and consumer confidence declining, we are worried that service sector activity slowed. A number of housing market reports are also due for release -- overall housing market activity is expected to remain anemic.

USD/JPY Rally Nearing Exhaustion?
After climbing to a fresh two-year high overnight, USD/JPY staged a sharp intraday reversal that left the pair near the day's lows. Since Prime Minister Abe came into office, he and various members of his government have made it abundantly clear that they won't retreat on their promise to pressure the Bank of Japan into greater monetary easing. The Bank of Japan meets on January 21st and it is widely believed that they will give in to Abe's demands and increase their inflation target to 2%. The BoJ has a tough enough of time as it is increasing inflation to 1% that a 2% target won't change their course of action. The latest economic reports show that consumer price growth is still negative (CPI is running at an annualized pace of 0.2%). Despite the recent weakness of the Yen, the Japanese economy continues to struggle. Manufacturing activity contracted at a faster pace in the month of December according to the survey conducted by Markit/JMMA. Retail sales were flat last month while industrial production dropped a whopping 1.7%. The only good news was in the jobless rate, which fell to 4.1% from 4.2% in November. Based on the economic outlook, the Bank of Japan has every reason to ease monetary policy again in the coming year. Therefore while USD/JPY appears to be nearing exhaustion and a move down to 85 is likely, dips should be looked at as an opportunity to buy USD/JPY at a lower level. No major economic reports are scheduled for release from Japan in the coming week.

AUD: More Than 30% Over Valued
This has been a week of consolidation for the Australian and New Zealand dollars. While NZD/USD fell to a fresh one-month low intraday, on a day to day basis, the currency pair has not changed much in value since Monday. Commodity currencies have fallen sharply over the past two weeks but even with these moves, they remain extremely overvalued. Based on purchasing power parity, the AUD/USD is more than 30% overvalued and NZD/USD is overvalued by 29%. The Canadian dollar's valuation is less heady, but the currency is still 15% more expensive than it where should be against the U.S. dollar. While currencies can be over and undervalued for long stretches of time, when the valuation hits extreme levels and are misaligned with fundamentals, there's a strong possibility for a correction. In the case of the Australian and New Zealand dollars, slower growth in China and uncertainty in the financial markets means another rate cut from the RBA is possible. Recent disappointments in New Zealand dollar have also led many investors to wonder whether the NZD/USD deserves its lofty valuations. While the NZD is more overvalued than the AUD, a massive current account deficit and the prospect of aggressive fiscal tightening by the New Zealand government over the next two years means that the AUD could outperform the NZD in the coming year. Next week will be a far busier week for the commodity currencies with Chinese and Australian PMI numbers on the calendar along with Canada's employment report.

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