EUR/USD Hits Highest Level In 14 Months

The S&P 500 climbed above 1,500 for the first time in five years while 10 year U.S. Treasury yields are hitting up against 2%, so USD/JPY should be trading higher right? Wrong. While all of the other major currencies benefitted from the "risk rally," USD/JPY failed to participate in the move, ending the day slightly lower against the greenback. After such an extensive rally, USD/JPY is in desperate need of a new catalyst and some traders may be hoping that tomorrow's U.S. Q4 GDP report and/or the FOMC meeting will provide it. Unfortunately we don't expect either one of these event risks to trigger much volatility for the greenback. Given the sharp decline in retail sales and increase in the trade deficit last quarter, everyone is looking for GDP growth to slow significantly. The current forecast is for only 1.1% growth, down from 3.1% in Q3. This is about the level our own expectation and even if GDP growth beats, it would need to be 2% or more for USD/JPY to rise. If growth is less than 1%, USD/JPY would decline but we would be surprised if GDP slowed that much in Q4.

As for the FOMC meeting, no changes to monetary policy are expected and there will be no press conference or updates to economic forecasts either. If there are any changes to the FOMC statement, they will be minor. The overall tone of economic data has not changed much since the December meeting. While job growth slowed and the unemployment rate ticked slightly higher at the end of the year, retail sales rebounded, service and manufacturing sector activity expanded. Sales of new and existing homes declined between November and December but the last data the Fed had on hand in December were the October numbers and more homes were still sold in December versus October. Stocks also performed extremely well climbing to five-year highs while 10-year bond yields tested 2% for the first time since May. The IMF believes that the U.S. recovery is on track and expects U.S. to lead growth in Westernized nations this year. However with job growth slowing and consumer confidence plunging, the Fed won't be overly eager to remove stimulus. As a result, we expect the central bank to continue to say, "economic activity and employment have continued to expand at a moderate pace." They could remove the line that says "strains in the global financial markets" pose downside risks but the need for continued balance sheet expansion remains in place "if the outlook for the labor market does not improve substantially." If the Fed leaves the FOMC statement virtually unchanged, the impact on the dollar should be limited. However, if they change the statement enough to suggest that they have grown less dovish, we could see a new leg higher in USD/JPY.

EUR: Hits 14-Month Highs, Testing 1.35
Stronger-than-expected German economic data and weaker U.S. consumer confidence drove the EUR/USD to its highest level in 14 months. The currency pair has come within a whisker of the key 1.35 level and while it has yet to break above this technically significant price point, it appears poised to do so. The continuous rally in U.S. stocks also appears to finally have a positive impact on the currency. Euro-zone confidence numbers are due for release tomorrow and given the rise in German consumer sentiment, we believe that the optimism in Germany will carry through to the rest of the region. Spanish GDP numbers are also on the calendar and growth in the fourth quarter is expected to fall by 0.6%. While this certainly isn't good news for the euro zone's fourth largest economy, we expect EUR/USD traders to ignore the news, just as they did the sharp decline in Spanish retail sales reported this morning. Since 1.35 is a very important resistance level in the EUR/USD, we are certain there are a number of stops and option barriers at that level, which means a break may not be easy. However when the currency pair finally clears this point of contention, it could be smooth sailing to 1.37/1.38. Based on the amount of excess capital that still needs to return to the euro zone, we believe that eventually the currency pair will reach this level. In terms of German consumer confidence, our colleague Boris Schlossberg covered the release extensively. He said, German GFK consumer confidence printed at 5.8 versus 5.7 the month prior continuing the trend of improving sentiment surveys in euro zone's largest economy. Although Germany saw a slowdown in economic activity in Q4 of last year, consumers are optimistic about a rebound. According to GFK, consumers are expecting a gradual revival in the economy over the course of this year thanks to the present calm situation on the financial markets. Steady labor conditions have helped cushion consumer sentiment with the economic expectations component of the index rising to -11.3 points in January, after falling to -17.9 points one month earlier. Consumers' willingness to buy in January rose to 35.3 points from 20.1 in December while income expectations also rose to 36 points from 21.2 in December -- its highest level in six months.

RBNZ: An Air Of Optimism?
With the S&P 500 continuing to climb, it is no surprise to see a recovery in the New Zealand, Australian and Canadian dollars. Australia was the only country with economic data released over the last 24 hours and as we suspected, stronger Chinese data overshadowed weaker domestic conditions and boosted consumer confidence by the largest amount in more than three years. Australian businesses are now optimistic about the outlook for the global economy and hopefully this will translate into more investment domestically. In addition to the Federal Reserve, the Reserve Bank of New Zealand also has a monetary policy announcement tomorrow afternoon. When they last met, RBNZ Governor Wheeler did not sound overly eager to cut interest rates or intervene in the currency. At the time, the NZD/USD soared because the central bank governor said he expects domestic demand to strengthen, sees stronger housing market activity and less risk next year even though he also expressed concerns about the strong currency, rising joblessness and slower growth. There's no reason to believe that the RBNZ to alter monetary policy this month. While inflationary pressures have eased, consumer spending has been rising according to recent credit card spending reports, which should fuel stronger housing market activity. Overall, we expect the comments accompanying the RBNZ decision to contain an air of optimism.

GBP/USD Downtrend Remains Intact
After selling off aggressively on Monday, the British pound rebounded against the U.S. dollar and euro. No major U.K. economic reports were released overnight and that may be part of the reason why the GBP recovered. However a number of housing market indicators are scheduled for release tomorrow including net consumer credit, lending on dwellings and mortgage approvals. While the real estate market is holding strong in London, the rest of the country has not benefitted as much from low interest rates or the government's funding for lending program. The slowdown in growth in the fourth quarter most likely curtailed activity in the sector. Economists are looking for a slight improvement in consumer credit and mortgage approvals -- we believe that the risk is to the downside and the impact on the GBP should be relatively limited. Overall even with today's rebound, we believe that the downtrend in the GBP/USD remains intact.

JPY: Small Improvements In Economic Data
Japanese Yen crosses continued to consolidate near their recent highs with USD/JPY pulling back slightly and all of the other Yen pairs ticking higher. Small businesses in Japan grew slightly less pessimistic in the month of January as the Shoko Chukin index increased from 43.8 to 44.3. The outlook component of the report also rose three points to its highest level since April 2012 and this bodes well for first quarter growth. As we pointed out in yesterday's note, the rally in USD/JPY is losing momentum because there has been no additional catalyst for a further move higher. We know Japanese officials have no problems with the current level of USD/JPY and the question now is how much benefit the recent decline in the Yen has had on the economy. Japanese retail sales are scheduled for release this evening and an improvement could lift the Yen. If there starts to be more upside surprises in Japanese data than downside surprises, USD/JPY may have a difficult time extending higher. However if data takes a turn for the worse, speculation of additional easing by the Bank of Japan this year could reignite the rally in USD/JPY.

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