FX Review: Euro's On A Tear, Not So The Yen

EUR/USD rose to an 11-month high Friday and many investors are now wondering how much further the currency pair can rise. From a technical perspective, the pair is poised for a move to 1.35 with the 1.3485-1.3525 level being the next major area of contention. The weekly charts also show an inverse head and shoulders pattern that supports the case for further gains. From a fundamental perspective, the EUR/USD rally also has the blessing of the central bank. ECB Governing Council member Luc Coene said the level of the EUR is not a problem now and there is no need for additional easing. His views are consistent with other members of the central bank including ECB President Draghi who said he sees a second half euro-zone recovery. While excess EUR/USD strength is a problem, we don't believe that the central bank will be concerned until the EUR/USD reaches 1.37-1.40.

Economic data from Germany has also been very good which suggests that the euro zone's largest economy may continue to carry growth for the region. Business confidence rose to its highest level in seven months. With improvements in both current assessment and expectations for Germany, the IFO index rose to 104.2 from 102.4. The IMF downgraded their forecasts for euro-zone growth this year but between the strong increase in PMI and the solid rise in IFO, there's a very good chance that German growth will exceed expectations. The expectations component of the German IFO report tends to have a strong correlation with German GDP growth.

The central bank is also taking initial steps to unwind stimulus with LTRO payments, which was the biggest story in Europe. According to the central bank, 278 financial institutions plan to repay 137.2 billion euros next week, significantly more than the market's 84 billion euro forecast. This suggests that the balance sheets in the financial sector are stronger than expected which bodes well for confidence in the euro zone's banking system.

While the peripheral countries could still face weaker growth and elections in Italy next month could increase uncertainty, for the time being, the EUR/USD has fundamental and technical support for a continued rally to 1.35 and depending on how it behaves there, the rally could extend as high as 1.37.

USD: New Cast Of FOMC Votes Next Week
Friday was a day of continuation in the forex market and that meant more gains for USD/JPY, losses for the AUD/USD and pressure on the GBP. Unfortunately there was very little consistency in the price action of the greenback this week but that did not mean that the dollar wasn't on the move. The greenback traded lower against European currencies and higher against the Japanese Yen and comm dollars. This divergence is happening because there are far more interesting developments abroad than in the U.S. Growth in America is on track and most of the recent economic reports have been consistent with a gradual recovery. There were even silver linings in Friday's sharp decline in new home sales -- sales in November were revised higher while the median price of a home sold rose 1.3%. Next week, with the FOMC meeting and the nonfarm payrolls report on the calendar, we could see more consistent performance in the greenback as the dollar drives FX flows. This month's meeting is important because it will be the first opportunity for the new members of the FOMC to cast their votes. Originally, it was believed that on balance the new committee would contain more doves than hawks but based on recent comments heard from FOMC officials, there could be more support within the central bank for phasing out asset purchases than we would otherwise believe. The key is whether talk of ending Quantitative Easing this year gained any traction. However considering that there will be no press conference held, policymakers will probably avoid mentioning this topic all together. Meanwhile the sharp decline in jobless claims this month has led many investors to hope for stronger payroll growth. Optimism from the Federal Reserve and better than expected labor market numbers could help risk currencies and fuel further gains in USD/JPY.

GBP: GDP Contracts In Q4, Economy At Risk Of Triple Dip Recession
While the British pound dropped to a fresh one-year low against the euro, it held steady against the U.S. dollar. The U.K. economy contracted by 0.3% in the fourth quarter, which was weaker than economists had anticipated. On an annualized basis, growth was flat making it clear that if not for the positive boost from the summer Olympics and the Queen's Diamond Jubilee, the U.K. economy would be in much deeper trouble. If growth does not rebound this quarter, the U.K. would fall back into recession for the third time in four years. According to the GDP report, the manufacturing sector was hit the hardest with industrial production down 1.8%. On a quarter to quarter basis, construction activity increased but compared to last year, construction is down 11%. Prime Minister Cameron may be forced to look to the Bank of England for help especially as austerity weighs on growth. Between weak economic activity and missed budget reduction targets, the U.K. economy is prime for a sovereign debt downgrade by one of the big-4 rating agencies. A rough winter involving heavy snow and frigid temperatures puts the U.K. at risk of even weaker. If not for the increase in inflationary pressures, additional asset purchases by the Bank of England next month would be a given.

CAD: Killed By Weaker CPI
All three of the commodity currencies extended their losses against the greenback with the Canadian dollar falling the most on a percentage basis. Canada was the only country to release economic data over the last 24 hours and according to the report, consumer prices remained at a three-year low in the month of December. CPI fell 0.6% last month which left the annualized pace of CPI growth at 0.8% while core prices which excludes volatile items dropped from 1.2% to 1.1%. Lower inflationary pressures are one of the main reasons why the Bank of Canada said interest rate hikes were "less imminent" this week. Economic data has also been mixed with retail sales lagging despite strong job growth. Resistance in USD/CAD is at 1.02. In the past 48 hours, the AUD/USD has erased nearly all of this year's gains. The selloff was tipped by weaker Australian consumer price growth but the move could be getting a bit overextended considering that Chinese economic data has been good. More Chinese data is scheduled for release next week including the official manufacturing PMI report and if the government also reports stronger manufacturing activity, the AUD/USD could find support. The Reserve Bank of New Zealand has a monetary policy announcement next week -- no surprises are expected as interest rates are set to remain unchanged at 2.5%.

What Drove The Yen To Fresh Lows?
The Japanese Yen fell to fresh lows against many of the major currencies including the U.S. dollar, which was pushed to its highest level versus the Yen since June 2010. Yet the biggest milestones were reached by AUD/JPY and NZD/JPY, which rose to new four-year highs. Since the beginning of October, USD/JPY has now appreciated more than 17%. Such a strong move makes it extremely tempting to call for a top and/or exhaustion. There's no doubt that the rally in USD/JPY has become extremely overextended but so far, there are no signs that the rally is letting up. The latest extension lower in USD/JPY was caused by comments from Bank of Japan governor Shirakawa and the December BoJ minutes. While there was nothing new, the reminder that the central bank is worried about the outlook for the economy and plan continued, "powerful easing" was enough to drive the Yen lower. Some members also felt that it may be appropriate to buy more assets in the first half of 2013, others called for action in the currency and one member argued for scrapping the floor on interest rate deposits. While none of these actions were taken in December or at their latest policy meeting in January, the minutes show an incredible amount of dovishness within the central bank and highlight the possible alternatives for the new central bank governor. Shirakawa admitted that achieving their 2% inflation target won't be easy but they aim to do it as soon as possible. Inflationary pressures in Japan continued to fall with core prices dropping at a faster rate in December. Combating deflation is one of the primary motivations for the central bank's aggressively dovish monetary policy.

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