Does Spike In Italian Yields Matter?

The euro ended the day unchanged against the U.S. dollar which is impressive considering that Italian 10 year bond yields jumped 40bp to its highest level since November and Italy's stock market plunged close to 5%. The uncertainty created by the Italian election drove investors out of Italian assets as well as most European instruments. Stock markets across Europe plunged while Spanish bond yields spiked higher alongside Italian yields. The risk of investing in Europe has increased and yet the EUR/USD has managed to hold above 1.30. This suggests that either currency traders are overly optimistic and will join the selling soon or they are looking beyond the immediate mess to the possibility of a grand coalition between Bersani and Berlusconi, which would avoid the need for another election. While a grand coalition could initially be positive for the euro, in the long run, it may still be very difficult to implement further austerity. We believe that the key lies in Italian bond yields. If borrowing costs continue to rise for the rest of the week, it may be difficult for the EUR/USD to hold above 1.30. However if yields start to decline and the market seems pleased with a potential Bersani / Berlusconi coalition, it would be a stronger argument for a recovery in the EUR/USD. Euro-zone consumer confidence numbers are due for release Wednesday. The increase in business and investor confidence for Germany suggests that the possibility of an upside surprise. Investors will most likely look beyond these numbers because recent developments have created new uncertainty for the currency.

USD: Big Ben Dovish But Not Dovish Enough
The big focus during the North American session Tuesday was Federal Reserve Chairman Ben Bernanke's semi-annual testimony on the U.S. economy and monetary policy. Bernanke was dovish but at the same time, he also didn't dismiss the idea outright, which was enough to keep the dollar bid on a day with very strong economic data. Bernanke started his testimony saying that the benefits of easing outweigh the costs but went on to add that the Fed has the tools to tighten monetary policy and more QE may erode confidence in the Fed's ability to exit. Concern about unwinding asset purchases is the main motivation behind the calls to phase out asset purchases and it appears that in some ways, Bernanke shares this view. However with job market remaining "generally weak" and inflation well anchored, the Fed Chairman isn't in a rush to talk about exit strategies and instead confirmed that they intend to sustain easing for as long as needed. Economic growth is picking up this year but he is worried that the Sequestration could cause significant economic burden and for this reason, the well-mannered dove did not want to rush to any conclusion. In other words, Bernanke neither supported the idea of ending Quantitative Easing or defended it vigorously, which was enough to keep the dollar bid against all of the major currencies except for the Japanese Yen. However this morning's U.S. economic reports should ease some of Fed's concerns about the economy and make those members of the FOMC who support tapering off asset purchases more confident in their views. Consumer confidence soared and new home sales rose by its largest amount since April 1993. The Conference Board's consumer confidence index hit 69.6 in the month of February, up from 58.6. Improvements in the labor market and rise in equity market valuations made investors more optimistic about present and future conditions and this uptick is consistent other sentiment reports. The housing market is also gaining momentum according to the Commerce Department who reported a 15.6% increase in new home sales. This was the biggest increase in nearly 2 decades and brought the total amount of new homes sold to its highest level since 2008. The only problem is that the average price of a home sold dropped 5% but at least these homes are remaining on the market for a shorter period of time. There are definitely signs of increasing momentum in the housing market and this along with the rise in consumer confidence and manufacturing conditions in the Richmond region will sit well with the central bank. Durable goods and pending home sales are due for release Wednesday along with Day two of Bernanke's testimony to Congress, this time before the House.

GBP: Holds Steady In Europe And North America
The British pound ended the day lower against the U.S. dollar and euro but continues to hold up well considering the recent downgrade. We still believe that the currency pair is poised for further losses and Tuesday's sell-off could be just the beginning. U.K. economic data continues to surprise to the downside with home loans declining according to the British Banker's Authority and the CBI retail sales index falling to a 5 month low in the month of February. Consumer spending has been the Achilles heel of the U.K. economy and so far, it appears that there is no relief. The latest data suggests that consumer spending remained weak in February after falling in January. According to the Confederation of British Industry, grocers reported the largest decline in sales since November 2008 while clothing, furniture and non-store retailers posted strong growth. Still, the volume of orders placed with suppliers dropped to its lowest level since November 2011. This is terrible news for the British pound and does not bode well for GDP growth in the first quarter. Revisions to Q4 GDP are due for release Wednesday but we don't expect any major changes. If the U.K. economy proceeds at its current pace, it could be at risk for a double dip recession. BoE markets director Paul Fisher also spoke, explaining why he voted in favor of more easing in February. The monetary policy committee member believed Rather than a very large, rapid programme of asset purchases to avoid an imminent slump -- as was needed in 2009 and again in 2011-12 - a slower, more gradually supportive policy might be more appropriate. This could be the first installment of a more prolonged run of purchases at a somewhat slower pace than previously. This suggests that Fisher is not only supportive of more QE immediately but further additional easing beyond the initial move.

NZD: Trade Surplus Turns Into Deficit
The New Zealand and Australian dollars extended their losses against the greenback while the Canadian dollar stabilized. The New Zealand dollar dropped the most but the move was not driven by economic data. While the country's trade balance numbers were released this evening, the sell-off in the NZD/USD occurred throughout the European and North American trading sessions. This sell-off may have more to do with the NZD/USD's correlation with commodity prices. The currency pair has a particularly strong relationship with the price of copper and the 6% decline in copper prices since the beginning of the month foreshadowed the recent pullback in the NZD/USD. New Zealand trade numbers only added to the pain with the country's 534M surplus turning into a deficit of 305M in the month of January. The combination of weaker exports and stronger imports weighed heavily on trade activity. In contrast, it has been relatively quiet in the Australian and Canadian dollars. The AUD pushed slightly lower against the greenback while the CAD consolidated after seven-straight days of gains. No economic data is expected from any of the three commodity producing countries on Wednesday.

JPY: Expect BoJ Nomination Within 48 Hours
With the exception of NZD/JPY, all of the other Japanese Yen crosses stabilized against the greenback after yesterday's sharp slide. We are still in wait and see mode with the Bank of Japan. Haruhiko Kuroda is the leading contender for the post and according to officials in the opposition party, the Democratic Party of Japan is open to backing Kuroda for BoJ Governor. Muto seems to be the least favorite and apparently some DPJ officials are concerned about Iwata's previous criticism about the central bank. If Kuroda is nominated as BoJ Governor, Iwata could still be chosen as one of the Deputy Governors. We believe it is about time for the Prime Minister to make his announcement and we expect this to occur within the next 48 hours. When the announcement is made, we expect a knee jerk reaction in the Yen followed by a larger move once we hear from the new BoJ Governor. Abe's selection would still need to be confirmed by the upper and lower house but it appears that Kuroda would have the support of both. As mentioned yesterday, when the nomination occurs, we expect Kuroda to publicly affirm his commitment to easing monetary policy aggressively and reaching the BoJ's 2% inflation target within two years. It is important to remember that the Bank of Japan has not changed monetary policy this year. Shirakawa's plan is to increase asset purchases in 2014, leaving the door open for the new BoJ Governor to make changes this year. When the new central bank head takes office in April, he is widely expected to act aggressively. Japanese retail sales were due for release Tuesday night along with the Cabinet's Monthly Economic report.

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