Risk Aversion Up As U.S. Markets Take Another Hit

The Federal Reserve is worried about the U.S. economy and according to the FOMC minutes, a number of policymakers want more asset purchases next year. The U.S. dollar gave up part of its early gains after the FOMC minutes revealed a central bank that is committed to doing more and unfazed by the fleeting economic improvements seen in the month of September. Having unveiled an open ended asset purchase program the month prior, the fact that in October a number of participants wanted more asset purchases next year is a very bearish development for the U.S. dollar. Operation Twist ends in December and policymakers are worried that the problems in Europe and the U.S. Fiscal Cliff would slow the recovery even further. This instinct is probably right considering that the 6% slide in the S&P 500 is already making Americans nervous. Today's weak economic reports certainly didn't help. The FOMC minutes also showed that there is greater support for Janet Yellen's call to link interest rates to economic indicators such as unemployment and inflation than to a specific calendar date, which is the current policy. Between weaker economic data, the risk of the U.S. falling off the Fiscal Cliff and renewed dovishness by the Federal Reserve, it may be difficult for the dollar to sustain its rally.

Wednesday's economic reports paint of picture of a slow and struggling U.S. recovery that will require continued stimulus from the Federal Reserve. Retail sales turned negative for the first time in four months with consumer spending dropping 0.3% in October. While the bulk of the weakness was in motor vehicle demand, there was also a broad based decline that included lower spending on furniture, electronics, building materials, clothing and online purchases. This indicates that improvements in the U.S. labor market have not prevented American consumers from closing their wallets. Retail sales also fell 0.3% excluding purchases of autos and gas. According to the Commerce department, it is hard to say how much of the decline can be attributed to Hurricane Sandy because the data showed both positive and negative storm effects.

The 0.2% decline in producer prices was far less of a surprise considering that commodity prices decreased in the month of October. Oil prices dropped 6.75% last month and a consistent but not nearly as significant decline was also seen in the price of food. Inflation has not been a problem for the Federal Reserve for months now and with demand in the U.S. remaining weak and growth in Europe set to slow further, price pressures will not only be limited but won't affect the Fed's plans for easy monetary policy. Consumer prices are due for release tomorrow and we expect CPI growth to slow alongside PPI. Jobless claims, the Empire State and Philadelphia manufacturing surveys are also scheduled for release and we believe that jobless claims will be the most important. The Federal Reserve's primary focus is the labor market. With inflation muted and the manufacturing sector not expected to deteriorate enough to affect the Fed's plans for monetary policy, all eyes will be on the pace of job losses but watch out because there's a potential for an abnormally out of line jobless claims report because of Superstorm Sandy.

EUR: Euro Zone Back In Recession?
On Thursday, we will learn if the Euro zone fell back into recession in the third quarter. Q3 GDP numbers are scheduled for release and economists expect the region as a whole to have contracted by 0.1%. If growth between the months of July and September were negative, then the Euro zone would technically be in recession because growth also contracted in the second quarter. Considering that stagnant growth is expected for France and a small increase is expected for Germany, the weakness will come from countries that are already suffering significantly such as Spain, Italy, Cyprus, Belgium and Portugal. Continued austerity in all of these countries makes conditions very difficult for growth.

While the EUR/USD rebounded today, the psychological significance of Europe returning to a recession could be enough to strip the currency of its gains tomorrow. The key is Germany. Retail sales and trade activity improved slightly in the third quarter and if German growth exceeds expectations, the Euro zone may avoid a recession. Yet with the ECB and German officials warning of slower growth in the Euro zone's largest economy, even if the region escapes recession, the outlook is grim. Meanwhile, marginally better but still weak industrial production provided little support for EUR/USD. Instead the hope that bailout funds will be unlocked by the end of the month has some investors encouraged about the removal of one major risk hampering the euro. Wednesday morning, German officials said they expect a decision on Greece by the end of November and the EU believes additional steps will be taken on Spain by February.

GBP: BoE Won't Be Afraid To Ease With Inflation Rising
The British pound was hit by a combination of weaker employment numbers and dovish comments from the Bank of England. Jobless claims rose 10.1k in the month of October compared to expectations for no change. The unexpected increase in job losses comes on the heels of weaker service and manufacturing activity. While the unemployment rate declined and average weekly earnings grew at a faster pace in September, the October numbers should be more consistent with the rise in jobless claims. This deterioration in the labor market explains why the Bank of England cut its growth outlook. So while the central bank noted the increase in inflation, their concern about growth and warning that the economy will perform below its pre-financial crisis levels for the next three years made it clear that they are still open to the idea of easier monetary policy. BoE Governor King even said it would be very hard for the economy to grow without a lower exchange rate and more asset purchases would help to weaken the currency. While we still don't believe that the BoE will ease in December, the dovish tone of the Quarterly Inflation clearly indicates that the recent rise in price pressures will not stop them from increasing monetary stimulus, just as 5% inflation rate failed to stop them from launching Quantitative Easing in October 2011.

AUD: Rise In Consumer Confidence Fails To Offset Risk Aversion
Stronger consumer confidence did not stop the Australian dollar from falling sharply against the greenback. Continued risk aversion and trouble in the region weighed heavily on the currency. Consumer confidence increased for the third month in a row to a 19-month high despite the decline in business confidence. According to Westpac, the strength of the housing market is offsetting concerns about the mining sector and providing a boost to consumer sentiment. Wages also increased more than expected last month. However the AUD failed to hold onto its gains in the Asian session and instead fell sharply during the North American hours as U.S. stocks plunged on weaker U.S. data.

Of the three commodity currencies, the New Zealand dollar was hit the hardest by last night's decline in retail sales. NZD/USD fell to a fresh two-month low as expectations for a rate cut by the RBNZ next month grows.Surprisingly enough, the Canadian dollar managed to hold steady at a three-month low against the greenback. There was no economic data from Canada but the pullback in U.S. consumer demand and its implications for Canadian growth is being offset by a rise in oil prices. Canadian manufacturing and existing home sales are scheduled for release on Thursday -- neither of these reports are expected to have much impact on the Canadian dollar. According to Bank of Canada Deputy Governor Agathe Cote, monetary policy will remain very stimulative to counter external headwinds. Commodity currencies will continue to trade on risk appetite and the market's reaction to U.S. data.

JPY: Sells Off Aggressively In Anticipation Of More Stimulus From LDP
Of all the major currencies, the Japanese Yen was the day's biggest market mover. The Yen collapsed after Prime Minister announced plans to dissolve the lower house on November 16. This paves the way for general elections one month later on December 16. There is a very good chance that the LDP will win majority, which means former Prime Minister and current LDP leader Shinzo Abe will become the next leader of Japan. Shinzo Abe has been a major champion of easy monetary policy and pro-growth measures. Just last night, he called for a change in Bank of Japan law that would not only limit the independence of the central bank but set a new 3% inflation target that would force the BoJ to take "unlimited action" to achieve this goal. The current inflation target is 1% and given the deep deflationary conditions in Japan, 3% will be extremely difficult to achieve without aggressive money printing that will undoubtedly be negative for the Yen. Political uncertainty is coming at a terrible time for Japan but moving forward with elections will help Noda avoid a no confidence vote on his unpopular Cabinet and gain support for issuing more bonds to finance their growing deficit. We had expected the Bank of Japan to ease monetary policy as quickly as next week because of rapidly deteriorating economic conditions but the latest political developments could increase their level of aggressiveness and longevity of easy monetary policy.

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