Is The Euro Zone Out Of Recession?

Having sold off for three consecutive trading days, the EUR/USD officially rejected the 1.34 level. The sell-off was triggered by a combination of U.S. dollar strength and mixed euro-zone data. European stocks ended the day in positive territory but traders were not impressed with the latest economic reports. Euro-zone investor confidence rose to its highest level in three years but a drop in industrial production raised concerns. We feel that worries about IP are overblown especially since the data was for the month of June. Tomorrow's euro-zone and German GDP numbers are expected to show the region rising out of recession. After six straight quarters of contraction, economists are finally looking for a modest expansion that could lend support to the euro. However with German retail sales falling sharply in the second quarter, we cannot rule out a downside surprise and perhaps some of the traders selling euros today are also doing because they feel the GDP numbers could miss expectations. German investor confidence index rose to 42 from 36.3 but the big surprise was in euro-zone investor confidence. According to the ZEW Center for European Economic Research, the "First signs of an end to the recession in important euro zone countries may have contributed to the indicators rise. This is also reflected by the strong increase in economic expectations for the euro zone. Furthermore, the economic optimism is supported by the robust domestic demand in Germany." Green shoots are appearing across the region and investors have responded well to the news. Unfortunately the euro failed to benefit from less pessimism because of ongoing skepticism about euro-zone growth caused in part by the European Central Bank's recent decision to lower their GDP forecasts.

GBP: Will BoE Minutes Make Or Break Sterling?
The time has come for the biggest event risk facing sterling this week -- the Bank of England minutes. Monetary policy is driving the direction of currencies and in the case of the British pound we want to know how many members voted for new unemployment rate threshold, which was Mark Carney's first attempt to guide monetary policy lower. If the decision was unanimous and everyone agreed that it was critical to make their intention to keep interest rates at extremely low levels for the next two-to three years, then this dovish bias could drive the GBP/USD to 1.53. If some members disagreed and felt the new approach was unnecessary, the GBP/USD could rebound to 1.56 as this would suggests fewer doves on the monetary policy committee. We will also be looking to see if Fisher and Miles voted for more Quantitative Easing and if any other policymaker (perhaps Carney) joined the minority. If that is the case, it would add pressure on the pound. Yet there is also scope for a move higher. Recent economic data out of the U.K. has been strong which reduces the need for extreme dovishness and inflationary pressures have subsided according to the latest CPI report. Consumer prices stagnated in the month of July, driving year over year CPI growth down to 2.8% from 2.9%. Aside from the Bank of England minutes, U.K. employment numbers are also scheduled for release. The latest PMI numbers show improvement in the employment conditions of the service and manufacturing sector, which suggests that the potential for continued upside surprises in U.K. data.

USD: Retail Sales Keeps Debate On Taper Going
The U.S. dollar traded higher against all of the major currencies today on the back of decent retail sales numbers. While the level of consumer spending was far from impressive, consumption was firm enough to sustain speculation that the Federal Reserve will taper asset purchases this year. Retail sales growth slowed to 0.2% in the month of July from 0.6% in June but excluding volatile auto and gas purchases, spending grew 0.4% after stagnating the month prior. The dollar had been trading higher for most of the morning and extended its gains after the market learned that retail sales grew for the fourth consecutive month. We had hoped to see retail sales grow by more than 0.7% but based on the reaction in the foreign exchange market, it is clear that investors believe the data is good enough to keep the hawks talking about reducing purchases over the next two months and that is good for the dollar. At the same time, inflationary pressures are muted according to import prices, which grew only 0.2% in July compared to a forecast for 0.8% growth. Producer prices are scheduled for release tomorrow and the same softness in price pressures is expected. Overall we do not feel that the data is strong enough to solidify expectations for tapering, which means investors are left guessing on how quickly the central bank will act. Federal Reserve President Lockhart agrees that tapering could happen in the next three months but as a non-voting member of the FOMC, he cannot act on his views. Therefore until we get the release of the July FOMC minutes on August 21 and the Jackson Hole Federal Reserve Summit on August 22, we won't get much in the way of additional clarity on where the central bank stands because the rest of the data this month is second tier. This suggests that while we have seen a nice rally in the U.S. dollar in reaction to retail sales, we continue to see the EUR/USD trading between 1.3100 and 1.3450 and the GBP/USD between 1.53 and 1.57 in the near term. USD/JPY on the other hand could be poised for additional gains because at the end of the day, the Fed is still gearing up to reduce asset purchases - the only question is when. There is significant resistance in USD/JPY near 98.75 but 10-year Treasury yields have responded very positively to today's data and if they continue to rise, this level can be broken. St. Louis Fed President and FOMC Voter James Bullard will be speaking tomorrow on the Challenges of Monetary Policy and will meet with the news media following his speech. While he is generally considered one of the less dovish members of the central bank, when we last heard from him in on August 2, he said the economy is improving modestly but urged the central bank to wait for more evidence of recovery in the labor market and economy before tapering asset purchases.

AUD: Hit By Weak Business Confidence, Bleak PEFO Outlook
The Australian, New Zealand and Canadian dollars continued to weaken against the greenback on the heels of U.S. dollar strength and weaker than expected Australian data. Business confidence in Australia dropped to its lowest level since November 2012 last month reflecting uncertainty in the global economy, concerns about Chinese growth and weak domestic conditions. While Australian businesses felt that current conditions remain unchanged, their worries about exports and profitability caused the NAB Business Confidence index to drop from -0.4 to -2.8 for the month of July. The recent interest rate cut by the Reserve Bank and upside surprises in Chinese data may have eased some concerns but the risk posed by Fed tapering on the global economy is still a worry for Australian businesses. The Pre-Election Budget released last night shared some of these same concerns. While the budget confirmed a deficit of A$30.1 billion this year, it included an alternative scenario with a weaker jobs outlook. This scenario accounts for the impact of 115k people out of work for more than one year, which is a bleaker forecast than the government's current projections for the jobless rate, which is expected to drop from 6.25% to 5% in three years. The main area of vulnerability is terms of trade, which are in a decline and subject to "volatile and unexpected changes to the global demand or supply of commodities." Australian consumer confidence numbers are scheduled for release tonight and unfortunately we expect sentiment to remain weak with jobs dropping in the month of July. New Zealand has second quarter retail sales numbers scheduled for release while Canada has another house price index on the calendar.

JPY: Fundamental Drivers For USD/JPY Rally
A second consecutive day of recovery in USD/JPY has sparked speculation of a bottom and we believe that further gains are possible since today's rally was caused by factors that are fundamentally positive for USD/JPY. The initial rally in USD/JPY during the Asian session was triggered by an article in the Nikkei, a leading newspaper in Japan that said Prime Minister Abe would balance an increase in the consumption tax with a reduction in corporate taxes. The goal would be to offset the drag on the economy and to attract foreign direct investment. Japanese stocks responded positively to the article, rising more than 2.5%. With the positive correlation between the Nikkei index and USD/JPY, the rally in stocks helped to lift the currency. The decent U.S. retail sales report released at the start of the North American trading session lifted the pair further and gains were supported throughout the day by a rise in U.S. yields. Yet the real test is whether the rise in yields can be sustained. If U.S. Treasury yields continue to press higher, USD/JPY could find the momentum to break above 98.75, a key resistance level. While complementing an increase in the consumption tax with a reduction in corporate taxes could be a smart tactic, a decision won't be made until October, which makes it is nothing but speculation at this point. For the time being, Japan is still in the midst of recovery. Industrial production was revised higher for the month of June while Machine orders dropped less than expected. The Bank of Japan also released the minutes from their July monetary policy meeting where they upgraded their assessment of the economy.

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