Bullard Says Next Meetings Are Key

The U.S. dollar traded lower against most of the major currencies Wednesday. Compared to many other G10 nations, the U.S. producer price report is one of the least interesting pieces of data on Wednesday's calendar. Inflationary pressures in the U.S. have been muted for the past year and Wednesday's flat PPI figure confirms that prices remain steady. After rising 0.8% in June, economists anticipated another 0.3% increase but PPI was unchanged as the declines in auto and raw material prices restrain growth. Excluding food and energy prices, producer prices grew only 0.1%. This data as well as Thursday's CPI report should show that inflation poses no major threat to the U.S. economy at this time but the fear that inflationary pressures could accelerate in the future is part of the motivation for tapering asset purchases this year. Unlike some of his peers, St. Louis Fed President and FOMC Voter James Bullard expressed caution over the central bank's eagerness to ease. He said the central bank's forecasts have been too optimistic and called for caution. More specifically, he feels that the FOMC needs to see more data on the second half performance of the economy before making a decision to taper asset purchases. He feels that October is an "unlikely venue for important policy action," because of no press conference and this leaves September and December as the key meetings. Taking comments from other Fed officials into consideration, we continue to believe that the central bank will act next month but the size of tapering is up for discussion.

A number of U.S. economic reports are scheduled for release Thursday including jobless claims, CPI, industrial production, the Treasury International Capital flow report along with the Empire State and Philadelphia manufacturing surveys. Of these releases we believe that the Empire and Philly Fed surveys will be the most important because they are the most up to date measures of how the U.S. economy is doing. If manufacturing activity slows like some economists expect, U.S. yields could retreat further, dragging down the dollar. The Treasury International Capital flow report is also interesting and will tell us if foreigners increased their exposure to the greenback as it rallied in the month of June. No major changes are expected in jobless claims or consumer prices.

GBP: Supported By Consistent Improvements In Data While the British pound traded higher against most of the major currencies Wednesday, the rally was modest. The Bank of England minutes and U.K. employment numbers failed to trigger the big move in sterling that we had been hoping for. Nonetheless, the steep drop in jobless claims boosted the currency and spurred speculation that the central bank's unemployment target will be reached before 2016. According to the MPC minutes, the decision to leave interest rates and the Quantitative Easing program unchanged was unanimous. However on the unemployment rate threshold, one member (Martin Weale) voted against forward guidance to "register his preference for a time horizon for the first inflation knockout that was shorter than proposed," on the fear that it would undermine the central bank's inflation fighting mandate. This slightly hawkish bias combined with stronger employment numbers drove sterling higher and now it will be up to Thursday's retail sales report to take GBP/USD up to 1.56. Economists are looking for a sizeable uptick in consumer spending and we agree that the data could be strong. Consumer confidence rebounded to a 3 year high in the month of July and according to the British Retail Consortium, sales rose 2.2% year over year last month, up from 1.4% yoy in June. Consistent improvements in U.K. data should keep sterling bid.

EUR: Shrugs Off News That Euro Zone Is Out Of Recession
According to the latest euro-zone GDP figures, the region is technically out of recession. After contracting for 6 straight quarters, the economy finally managed to expand by 0.3% in Q2. Thanks to improved weather conditions and faster industrial production stronger growth was reported in both Germany and France. While Germany never fell into a recession in this cycle, France did and managed to rise out of it in Q2. Unfortunately the euro received no support from the stronger GDP reports. The problem is that investors are still worried about the high level of unemployment, drag from fiscal consolidation and tight credit conditions. Recent economic data, particularly out of Germany have been good but in their latest monthly bulletin released last week, the ECB predicted that Euro-zone growth will contract by 0.6% in 2013, down from than their prior outlook of -0.4%. GDP is also predicted to rise 0.9% in 2014, less than the previous estimate of 1%. In response to these weak projections, the ECB will be forced to keep interest rates low for the foreseeable future. Based on these reports, the economy could be performing better than the central bank's projections but only time and further PMI reports will tell.

NZD: Soars On Strong Data, More To Come?
All of the three commodity currencies rebounded against the U.S. dollar Wednesday thanks to better than expected economic data. The New Zealand dollar was the best performer, rising approximately 0.8% against the greenback. New Zealand retail sales surged 1.7% in the second quarter. Sales volumes rose in 12 out of 15 retail categories with volume excluding fuel and vehicles rising at its strongest pace since the fourth quarter of 2006. Yet the sell-off in AUD/NZD was limited by an equally surprising rise in Australian consumer confidence. The Westpac index rose 3.5% to the highest level since March. It has been a long time since we have seen upside surprises in Australian data and that may be part of the reason why investors are eyeing the improvement with caution. In Canada, house prices rose 0.7%, compared to expectations for a 0.5% increased. More housing market reports are scheduled for release from Canada Thursday with existing home sales on the calendar. At the same time, the sustainability of gains in the NZD will hinge on the New Zealand business manufacturing PMI index and consumer confidence. If these reports beat expectations like retail sales, AUD/NZD could find itself trading back near its August lows. Australian average weekly wages are scheduled for release but this May report usually does not have a significant impact on the AUD.

JPY: Data To Show More Demand For Foreign Bonds
Like the U.S. dollar, the performance of the Japanese Yen Wednesday was mixed. USD/JPY, EUR/JPY and CHF/JPY declined, while GBP/JPY, AUD/JPY and NZD/JPY. No economic data was released from Japan but the 1% recovery in the Nikkei and steady U.S. yields helped USD/JPY avoid steeper losses. As we mentioned on previous occasions, USD/JPY traders need to keep a close eye on U.S. yields. If yields start to fall, USD/JPY will most likely follow suit but if yields extend their gains, USD/JPY could test 100. The Ministry of Finance's weekly portfolio flow report was due for release Wednesday evening and the data was expected to show Japanese investors buying foreign bonds for sixth week in row. Up until July of this year, Japanese investors were net sellers of foreign bonds but as U.S. yields continued to rise investors started to reconsider their domestic exposures. Banks, pension funds and mutual funds led the buying as rising yields abroad and concerns that the Yen will weaken in the long term forced Japanese investors, large and small to look abroad.

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