U.S. Dollar: Countdown to FOMC
Based upon the price action in the currency markets over the past 24 hours, it appears that after one day of respite, risk appetite has soured once again. The U.S. dollar traded higher against all of the major currencies except for the Japanese Yen as investors flocked into the safety of the lowest yielding currencies. Stronger U.S. economic data failed to help the dollar rise against the Yen, the currency pair that most accurately reflects the market’s attitude towards the U.S. economy.
Counting Down to FOMC
The big event risk tomorrow is the Federal Reserve’s monetary policy announcement. For the financial markets, the FOMC meeting is one the most potentially market moving events. Given the recent trend of weaker U.S. economic data, the Federal Reserve is faced with the tough decision of ignoring or acknowledging the acceleration in job losses and the decline in consumer spending. Having upgraded their assessment of the economy back in December, the Fed may not want to give the impression that they are flip-flopping based upon every piece of incoming data. Although recent data warrants a more cautious outlook by the Fed, the consequences of downgrading their assessment of the economy far outweigh the consequences of downplaying the latest reports. If the U.S. central bank suddenly grows more pessimistic, it could exacerbate the slide in equities and trigger further risk aversion in the forex markets because traders will think that in the eyes of the Fed, the deterioration could continue. If the statement is left unchanged and the tone remains relatively upbeat, the dollar could rally against the Yen but the reaction in the forex markets would probably not be as volatile. Therefore we believe the Fed will simply signal that the latest deterioration in data is a just a bump in road. As usual, the 3 things investors we will be looking for tomorrow is the tone of the FOMC statement, changes to the discount rate and any updates to their plans to end emergency programs. We don’t expect much from the Fed since they already provided details to shut down a large portion of their liquidity programs last month.
U.S. Budget Deficit Could Hit $1.35 Trillion, President Obama to Announce Spending Freeze
Meanwhile the Congressional Budget Office announced that the 2010 budget deficit could hit $1.35 trillion, the highest level since World War II. This report is released ahead of President Obama’s State of the Union Address on Wednesday night, where he is expected to call for a 3 year freeze on discretionary spending. The CBO also said the economy will probably grow at a very modest rate over the next few years and if that is true, it would reinforce the Federal Reserve’s plans to keep interest rates at very low levels for an extended period of time. The deficit is smaller than initially estimated by the CBO but the sheer size of the deficit will weigh on President Obama’s popularity. The spending cuts are predicted to save approximately $250 billion. The cutbacks in spending by the U.S. government have both positive and negative implications for the U.S. economy. On the one hand, it reduces the country’s obligations which could appease foreign investors but in order for the economy to stage a strong recovery, government spending is critical.
Economic Data Preview and Review
Aside from the FOMC announcement, new home sales are also due for release tomorrow morning. After the abysmally weak existing home sales figures reported earlier this week, there is a good chance that the original expiration of the tax credit also affected new home sales. This morning, the Conference Board’s consumer confidence report was released and the data was better than the market had anticipated. For the third month in a row, the Consumer Confidence index rose from an upwardly revised 53.6 to 55.9, the strongest level since August 2008. Since the Conference Board report follows the UMich survey, it tends to elicit only a limited reaction in the U.S. dollar. According to the details of the report, consumers grew more optimistic about the current and future conditions and less pessimistic about their ability to find jobs. The Richmond Fed index also rose from -4 to -2, reflecting a slower contraction in manufacturing activity.
Despite strong demand for Greek bonds and better than expected economic data, the euro refuses to rise. Bears are in control with the latest decline the currency pair attributed to risk aversion, dollar strength and comments from ECB officials. Monetary policy committee member Nowotny said this morning that the current level of the euro is justified by fundamentals and the region’s recovery is dependent upon forex stability. In other words, if the euro stays at or below current levels, it will help the recovery but if it starts to rise back towards October or November levels, the pace of recovery in the Eurozones could slow. In the meantime, German business confidence increased for the eighth month in a row, hitting an 18 month high in the process. Strong demand from Asia has helped to offset the decline in domestic consumption which is interesting because it indicates that Germany has become very sensitive to Chinese growth. Exposure to China may also be one of the reasons why the euro has been underperforming despite the successful Greek bond auction. Inflationary pressures are picking up as well with German import prices rising 0.5 percent in December. Although German consumers have cut back, French consumers have been spending with vengeance particularly during the holiday shopping season which should lend support for Eurozone retail sales. Meanwhile, the Swiss Franc weakened slightly against the euro following a decline in the UBS Consumption Index.
The British pound fell aggressively following the disappointing fourth quarter GDP report. The market had originally forecasted for GDP to rise by 0.4 percent but instead, it rose by only 0.1 percent, leaving annualized growth at -3.2 percent. In our daily report yesterday we talked about how we were skeptical about the market’s growth forecasts given the drop in average retail sales and the wider trade deficit in the last three months of the year. Now we know that growth did not live up to everyone’s lofty expectations. Nonetheless despite the smaller rise in GDP and the accompanying sell-off in the British pound, the U.K. economy is officially out of recession after six straight quarters of negative growth. This is only bittersweet considering that Britain was the only G7 country still in recession in the fourth quarter and compared to the rest of the world, growth is still very modest. For example, when the U.S. economy came out of recession in the third quarter, the economy grew by 2.2 percent. On a relative growth basis, the U.K. is clearly the underdog and it remains to be seen whether positive GDP growth can be sustained – based upon the data that we have so far received in the month of January, there is a good chance that the recovery will continue.
The rally in U.S. dollar and sell-off in commodity prices pushed the Australian, New Zealand and Canadian dollars lower. No major economic reports were released from the 3 commodity producing countries overnight but the action will heat up over the next 24 hours. The Asian trading session starts off with the release of Australian consumer prices. Earlier this week, we learned that producer prices dropped significantly in the fourth quarter and if consumer prices follow suit, the Reserve Bank of Australia could refrain from raising interest rates next month. Speaking of rate decisions, the Reserve Bank of New Zealand has a monetary policy announcement scheduled at 3:00pm EST / 20:00 GMT on Wednesday. Although the central bank is not expected to raise interest rates, the recent improvements in economic data could pave the way for a rate hike before the summer. Back in October, RBNZ Governor Bollard said rates will remain unchanged until the second half of the year but in December he suggested that they could raise rates sooner thanks to a strong housing market. The RBNZ will most likely reinforce this view by recognizing the improvements in the economy and which may be enough to halt the decline in the New Zealand dollar.
Despite the Yen’s rally against the major currencies, the news that Standard & Poor’s downgraded the outlook for Japan’s sovereign debt rating from stable to negative is very bearish for the currency. Downgrading the outlook is the first step that rating agencies take before actually downgrading the rating. It is a warning to the government as well as investors that Japan needs to reduce its structural deficit or else they will face higher financing costs. The Yen shrugged off the downgrade as concerns about China triggered a wave of risk aversion across the forex markets. Meanwhile the Bank of Japan left interest rates unchanged last evening and did not alter their outlook for the economy. USD/JPY is trading below 90, raising concerns about whether the Bank of Japan will verbally or physically intervene in the foreign exchange market. Based upon the latest comments from Prime Minister Hatoyama, there is “no immediate need to take steps on stock falls or Yen rise.” For the first time since September, small business confidence has improved which suggests that the recovery is finally spreading to other parts of the economy. Trade balance figures are due for release this evening and demand from China is expected to boost the trade surplus.
USD/JPY: Currency in Play for Next 24 Hours
The currency in play for the next 24 hours is USD/JPY. The Japanese trade balance due for release at 00:50GMT or 7:50PM EST. The U.S. will release its new home sales report at 15:00 GMT or 10:00 AM EST followed by the FOMC announcement at 19:15 GMT or 2:15PM EST. USD/JPY is currently trading in the Sell Zone which we determine using Bollinger Bands. After breaching through the critical 90.00 level, which was not only a psychological point but also where the 50 and 100-day SMA sat, the pair is on track to test the 23.6% retracement of last year’s low and high at 88.75. The downtrend in the currency will remain intact as long as USD/JPY does not break back above the 1st Standard Deviation at 90.50.