By DailyFX - US Dollar - This week is make it or break it week for the US dollar. The foreign exchange market has turned...

... very dollar bullish after a series of upside surprises in economic data, causing a sharp plunge in rate cut expectations.


The Fed funds curve is now pricing in steady
rates for the first half of the year and slim chances for even one
interest rate cut by December. However, these expectations can turn on
a dime, just like they have over the past few weeks. We have a lot of
very important data due for release this week and they can either make
it or break it for the dollar by fueling more gains or causing a
reversal. The main releases that we are watching include the FOMC
statement, Gross Domestic Product (GDP), the Institute of Supply
Management Manufacturing survey (ISM) and Non-Farm Payrolls (NFP).
Each report will build on the next to help us gage how the ISM report
and non-farm payrolls, which are the two most market moving indicators
for the US dollar will fare. We start the week off with the Conference
Boards consumer confidence report tomorrow morning. The Conference
Board report is far more reliable than the University of Michigan
consumer confidence survey because it polls a larger group of people.
Consumer optimism is expected to hit the highest level since May 2002
thanks to falling gasoline prices, low jobless claims and a stock market
that is hovering near record highs. The 3 year high reported by the
University of Michigan survey earlier this month also suggests that
tomorrows report will be dollar bullish. If confidence proves to be
as strong as the market expects, it will set the tone for the week by
signaling a strong GDP report and a hawkish FOMC statement on Wednesday.
However if confidence slips below Decembers level, traders will
begin to question the continued resilience of the US economy and will
punish the US dollar as a result.

Euro - Demand from central banks as well as continually hawkish
comments from European Central Bank officials have helped to prevent the
EUR/USD from making a new year to date low. ECB President Trichet added
credibility to the hawkish comments made by a number of his monetary
policy committee members since the last ECB meeting. This weekend in
Davos he said that the “fastest money supply growth in 17 years
validates the recent rate hikes and looking ahead there is still a
risk that the recent rebound in oil prices could lead to an inflationary
spiral. This morning, ECB member Liebscher added that the ECB has to
act preemptively which indicates that the central bank is sending a
clear message to the market about their plans to raise interest rates
again this quarter. In fact, depending upon how aggressive oil prices
rebound, the ECB could even deliver an interest rate hike in February.
As for central bank demand, last Friday, Russia reiterated their plans
to diversify their reserves into the Euro, Sterling and Yen at the
expense of the US dollar. Aside from Russia, there is speculation that
many central banks have orders to buy Euros below the 1.29 level.
Looking ahead, manufacturing PMI reports from various countries within
the Eurozone are due for release along with the German consumer price
index. The increase in the Value Added Tax is expected to weigh on
manufacturing sentiment, but our main focus will be on the expected
increase in the annualized CPI growth rate to 2 percent, which would be
back to the ECBs target level. This should increase the pressure on
the central bank to raise rates.

British Pound - The British pound underperformed both the US dollar
and Euro after Bank of England monetary policy member Blanchflower said
that inflation could fall back below the BoEs 2 percent target by the
end of the year as slack in the labor market pushes wage growth lower.
Although Blanchflower typically sides with the doves, which means that
he prefers looser monetary policy, his comments added salt to wound
after the minutes from the latest BoE meeting revealed that the surprise
rate hike was supported by only a small majority. The clear hawkishness
of the ECB and the strong possibility that the Federal Reserve monetary
policy statement will also be hawkish later this week has led the market
to shrug off the solid CBI distributive trades number reported earlier
this morning. The retail sales gage jumped from 25 to 30 while the
expectations index surged form 4 to a two year high of 22. This
strength indicates that the retail sector is still holding up the
economy which suggests that the central bank could still raise rates in
March or April.

Japanese Yen - Weak retail sales has sent the Japanese Yen plunging
against the majors. Domestic spending has long been one of Japans
biggest problems because even though corporate profitability has
increased, there has been minimal wage growth. We now have evidence
supporting the Bank of Japans decision to leave interest rates
unchanged last month. There has not been enough growth in both consumer
spending and consumer prices to justify tighter monetary policy. In
fact, had the BoJ raised rates, they may have jeopardized the
countrys fragile recovery. Even though European officials have
been calling for some action to stem the Yens slide against the Euro,
we do not expect much criticism about the currencys weakness at the
G7 meeting. The USD/JPY rate is not worrisome enough for the US to back
the claim of European officials. Treasury Under Secretary Adams has
already hinted that this will be the US stance when he said their
cautious economic policy seemed appropriate. Furthermore, the weak
growth in Japan validates the governments need to keep the Yen weak.


Commodity Currencies (CAD, AUD, NZD) - The drop in oil and gold prices
today forced the Australian and Canadian dollars to shrug off stronger
business confidence. According to the National Australia Bank, business
confidence rebounded from 2 to 4. In Canada, the survey of
manufacturing conditions increased from -6 to -5. Business conditions
moved back to positive while wage growth accelerated. However, neither
of these reports will shift the monetary policy outlook of the
Australian and Canadian central banks as both remain solidly neutral for
the time being. The New Zealand dollar on the other is holding steady
thanks to a slightly more hawkish central bank and the prospects for a
smaller trade deficit in the month of December.


Kindest Regards,

Kathy Lien
Chief Strategist
Forex Capital Markets LLC
32 Old Slip, 10th Floor
New York, NY 10004
Tel (212) 897-7660
Fax (212) 897-7669
E-mail: klien@fxcm.com

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