USD Rallies As Yields Continue To Fall

Despite the third straight day of declines for U.S. yields, the dollar traded higher against all of the major currencies except for the Japanese Yen. This morning's U.S. economic reports validate the Federal Reserve's decision to wait to taper. According to the Conference Board, consumer confidence declined in the month of September, which was consistent with the drop reported by the University of Michigan. Consumers are feeling nervous about the outlook for the U.S. economy, the fiscal showdown in Washington and the rise in borrowing costs. Manufacturing conditions in the Richmond region is also stagnating this month after expanding strongly in August, raising concerns about the sustainability of the sector's recovery. The Fed's much treasured housing market recovery is looking vulnerable with S&P Case Shiller reporting a slower pace of growth in July house prices but thankfully this weaker release was offset by the Federal Housing Finance Agency's report that house prices rose at its strongest pace in March. Durable goods and new home sales are scheduled for release on Wednesday.

EUR: German IFO, ECB Talk
For the third consecutive trading day, the euro weakened against the U.S. dollar. The losses were small but represents hesitation in the market. This morning's German IFO report was bad enough to keep the euro from rallying but also strong enough to keep it from falling sharply. Business confidence improved slightly in the month of September but less than economists had anticipated. The IFO survey rose from 107.6 to 107.7 versus a forecast of 108.0. Businesses were less optimistic about current conditions but more hopeful that activity will improve in the coming months. This data suggests that while the ECB is concerned about the outlook for the euro-zone economy and certain economic reports have flashed signs of weakness, the momentum is still positive going into the fourth quarter. We also heard from a number of ECB policymakers this morning. According to Nowotny, no additional liquidity is needed at the moment but the ECB will discuss if new LTRO is needed. He felt that it is important to show that the central bank has more instruments at its disposable even if it is not necessary to utilize them at this time. Costancio seems to agree - he also said the central bank has several policy instruments available if needed and forward guidance is helping. Coeure did not talk about the possibility of LTRO but said the central bank's expectations for a gradual recovery have been confirmed but he expects rates to remain low for an extended period of time and there is no need to change forward guidance. It is clear that euro-zone policymakers are comfortable with the current level of monetary policy but felt the need to remind the markets that they are dovish and will remain so until there are consistent improvements in euro-zone data.

GBP: UK Policymakers Comfortable With Current Stimulus
Like many other major currencies, the British pound traded lower against the U.S. dollar but held steady against the euro. According to the British Bankers' Association, the number loans for house purchases increased less than expected in the month of August. Loans are still up from the prior month but lending was not as robust as economists had hoped. While there was no other economic data released Tuesday, we heard from a number of U.K. policymakers including MPC officials, Broadbent, Miles, Tucker and Bean. Broadbent felt that some market participants interpreted the central bank's forward guidance incorrectly. It was not a pledge to make no changes to interest rates for the next three years. If the unemployment rate falls more quickly than they expect, Broadbent felt that it would be right for the MPC to consider tightening monetary policy. While Miles stopped voting for more QE at the last meeting, he feels that the recovery is still vulnerable. While surveys show that the economy has strengthened, it is not back to normal and a sustained period of growth is needed to reduce slack. He felt that the UK does not need tighter policy right now and the market's view on the unemployment rate is too optimistic. Tucker said slack in the economy means that central bank is in no rush to withdraw QE. Deputy Governor Bean did not make any specific comments about monetary policy. Based on these comments, U.K. policymakers recognize the recent improvement in data but do not feel confident that the trend will last and therefore want to keep the level of stimulus intact for the time being.

CAD Shrugs Off Stronger Retail Sales
The Canadian dollar shrugged off better than expected retail sales numbers. Consumer spending rose 0.6% in the month of July, erasing the previous month's entire decline. Excluding autos, retail sales rose 1.0%, a much-needed recovery after the 0.9% contraction in spending the prior month. Unfortunately the gains were limited because the details of the report show that a large part of the increase was due to higher gasoline prices. Consumers spent more on clothing and general merchandise, but less on electronics, food and beverage. In other words, the improvements were not broadly based but nonetheless the recent pickup in job growth and Tuesday's increase in spending should still make the Bank of Canada's next move a rate hike and not rate cut. Of all the major currencies, the New Zealand dollar experienced the steepest losses after Fonterra said earnings in the second half of the year will be significantly lower. New Zealand is the world's largest dairy exporter and Fonterra is the country's largest dairy firm. Analysts credit the grim forecasts to last summer's drought and weaker growth in Australia. However it is also important to note that Fonterra raised its milk forecast for next year by 50 cents to a record high of $8.30 per kilogram of milksolids. According to the Chairman, higher prices "reflected continuing strong international dairy prices, particularly for whole milk powder driven by demand from Asia, and especially China." They still estimate to pay a dividend of 32 cents in 2014. So while Fonterra is not as optimistic about the outlook for the second half, the combination of higher milk prices, strong demand from Asia and a steady dividend tells us that one of the greatest risk for the country (slower Chinese demand) is less of a concern for some of New Zealand's largest exporters. Therefore we expected only limited losses in NZD against the USD but particularly against the AUD. New Zealand trade numbers were due out Tuesday evening and economists were looking for the deficit to narrow. However with manufacturing PMI dipping, a wider deficit is also possible. No economic reports are expected from Australian or Canada over the next 24 hours. Like the NZD, the Australian dollar extended its losses.

Expect Range Trading In USD/JPY This Week
The Japanese Yen traded higher against all of the major currencies Tuesday with NZD/JPY experiencing the steepest losses. With no Japanese data released overnight, the sell-off in the Yen crosses is a reflection of the ongoing anxiety of the markets. The Fed left asset purchases unchanged but they haven't completed eliminated the idea of tapering this year while the fiscal showdown in Washington is keeping stocks from rallying. The Nikkei was unchanged overnight and is taking its cue from the Yen. Japan was closed on Monday and after hitting 2 month highs last week, the quiet session also encouraged profit taking. Since there's not much U.S. data scheduled for release this week either, USD/JPY has been trading in a tight range that we expect to hold for most of the week. The 100 level should limit the top side for the pair while 97 should be downside support. Most of the Yen crosses are down only slightly Tuesday but the sell-off in the NZD/USD shaved more than 1% off the pair. The only piece of Japanese data on the calendar Tuesday night was small business confidence and we expect sentiment to continue to improve as Japan's recovery remains underway.

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