With Risk Tamed, FX Traders Look To Fundamentals

...
The U.S. dollar traded higher against all of the major currencies Monday, but the consistent performance of the greenback does not mean that risk on/risk off will start to drive currency flows. The S&P 500 has been on fire since the beginning of the year and while the optimism in stocks translated into strength for some currencies, others failed to follow. This may be a very busy week for U.S. data but with no major surprises expected from the FOMC meeting, GDP or NFPs, the impact on risk appetite and currency flows could be limited. We have seen quite a bit of divergence in the performance of currencies since the year began and this was because country specific factors are driving currency flows. Even on a day like Monday where the dollar appreciated against all currencies, the EUR, CAD and CHF lost nearly nothing to the dollar while the GBP and NZD fell sharply. When there are no major systemic risks in the market, relative fundamentals start to matter again. This will change however if there is a new shock to the financial market or we get unambiguously strong or weak data from the U.S. or China that prompts investors to readjust their positioning.

Monday's U.S. economic reports were mixed with orders for durable goods rising 4.6% in the month of December, up from 0.8% the previous month. While this wasn't a milestone for durables, because they can to be volatile, excluding orders for transportation equipment, durables increased 1.4%, which will provide a positive contribution to Q4 GDP. Pending home sales on the other hand dropped 4.3% last month. This pullback is not much of a surprise after seeing the decline in new and existing home sales. December in general was a weak month for the housing market but overall, low interest rates continue to support the sector. The S&P Case Shiller house price index is scheduled for release on Tuesday along with Consumer Confidence. The rise in stocks should have boosted sentiment but the payroll tax hike at the beginning of the year could weigh on the index just as it had on the University of Michigan's consumer confidence report.

EUR: Capital Inflows Are Only Beginning
The EUR/USD managed to hold onto its gains after breaking out of a two-week long consolidation on Friday. The currency pair did not tack on more gains but it also did not give up any ground. No euro zone economic data was released but German and French consumer confidence numbers are due Tuesday. With the gap between German and French growth widening, we expect to see consumers in Germany grow more optimistic as consumers in France grow more concerned. The divergence in the economic performance of the Eurozone's peripheral and core economies has not stopped investors from pouring money into the currency. To be more specific, money is returning into the euro zone after having left it during the height of the region's sovereign debt troubles and now it is returning. According to an analysis conducted by the Dutch Bank ING and reported by the Financial Times nearly 100 billion euros flowed back into the Eurozone in the fourth quarter, which is the equivalent to "about 9% of the economic output of Spain, Italy, Portugal, Ireland and Greece." "Net private inflows into the periphery countries totalled €93bn in the last four months of 2012, according to ING. In contrast, the first eight months had seen €406bn flow out of the five countries, equivalent to almost 20 per cent of gross domestic product in the periphery economies. In 2011, outflows from the periphery totalled €300bn." This means that there's still a lot of money parked outside of the Eurozone that could flow back into the country this year, fueling further gains in the EUR/USD.

Why Is the GBP Getting Pounded?
The British pound dropped to a 13-month low against the euro and five-month low against the U.S. dollar. The pound continues to get pounded by traders who are dumping the currency left and right on the fear that the Bank of England could ease monetary policy again over the next few months. Economic data has been very weak and if not for the upside risk to inflation the Monetary Policy Committee would have increased asset purchases already. Yet even with the potential of inflation trickling higher again, the MPC may soon find themselves with no choice but to boost stimulus. Incoming Bank of England Governor Mark Carney is certainly not adverse to the idea. Speaking in Davos over the weekend, the current BoC Governor who is set to become the new head of the BoE in June said "monetary policy in developed economies isn't maxed out and central banks should focus on achieving escape velocity for their economies." These comments imply that he firmly believes there is room for additional stimulus even if it means that it "may take a little longer" to hit their inflation goals. With no U.K. economic reports, scheduled for release Tuesday, the downtrend in the GBP will remain intact.

NZD: Trade Returns To Surplus
Of the three commodity currencies, New Zealand was the only country with economic data released over the past 24 hours and the data that we have seen caused quite a bit of volatility for the currency. In the month of December, service sector activity slowed significantly which could raise some concerns for the Reserve Bank of New Zealand, who meets later this week to decide on monetary policy but trade activity improved dramatically. For the first time in five months, New Zealand reported a trade surplus of 486 million, up from a deficit of -590 million in November. Exports rose 6.2%, which is good news for the country, but imports fell 19%. Meanwhile USD/CAD ended the day near its lows despite rating agency Moody's decision to downgrade six Canadian banks. By cutting the debt ratings of the country's six largest banks, Moody's raised red flags about the country's lending risk. They were specifically concerned about high consumer debt levels and the lofty real estate valuations. This makes the banks "more vulnerable to unpredictable downside risks facing the Canadian economy than in the past" according to Moody's. Thankfully there is no immediate risk of a sovereign downgrade, which is why the Canadian dollar shrugged off the news. Australian business confidence is scheduled for release this evening and it will be extremely interesting to see whether concerns about domestic growth or optimism about Chinese growth had a larger impact on confidence last month.

Slope Of USD/JPY Rally Should Begin To Flatten
USD/JPY climbed to a fresh 2.5-year high of 91.27 overnight but ended the North American trading session in negative territory. The losses were small but the fact that USD/JPY did not extend its gains confirms our belief that the slope of the USD/JPY rally should begin to flatten. USD/JPY has been in a very strong uptrend over the past two months and based on the comments from Japanese officials, we know that the government has no problems with USD/JPY rising to 100, but just because policymakers can tolerate USD/JPY at that level doesn't mean that it will get there. A move to 100 would involve an additional 9% rally and for that to occur there needs to be a further catalyst. The Bank of Japan's monetary policy meeting is now behind us and while the central bank shifted to a 2% inflation target, open-ended asset purchases won't begin until next year. Since Japan is left with the same level of stimulus between now and then, the steps that the BoJ have taken should no longer fuel additional gains in currency pair. This is not to say that the USD/JPY rally is over because the BoJ still plans to be one of the most aggressive central banks over the next two years, but the slope of the rally should begin to flatten. From a technical perspective, USD/JPY's break above 90 favors a move to the next resistance level of 95, where the 2010 highs lie but from a fundamental perspective, in order for USD/JPY to maintain its momentum, the Federal Reserve needs to grow less dovish or the Bank of Japan needs to revisit its 2013 monetary policy. There's still scope for easier monetary policy from the Bank of Japan this year, which would be a valid catalyst for another leg higher in USD/JPY. If there are very little improvements in Japanese data over the next few months, the new central bank governor could choose to kick off his term with a fresh dose of stimulus. The sell-off in the Japanese Yen is suppose to provide a tremendous amount of support for Japanese trade activity but as we have seen in the latest trade numbers, the positive impact has been limited. While trade with the U.S., Europe and most of Asia increased, Japan's territorial dispute with China has hit the export sector hard and almost completely offset the improvements in trade to other parts of the world during the month of December, when the yen weakened significantly. If Japan fails to reach a resolution with China quickly, the economy could continue to suffer the consequences. At this point, with the BoJ meeting behind us, it all rests on economic data. If there are no major economic improvements, the BoJ could be forced to act again which would put additional pressure on the Japanese Yen.

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