Time To Focus On The Euro

It has been a great week to be long euros but lets be clear, the strength of the currency had nothing to do with the economic outlook for the region. Instead, the rally was fueled exclusively by U.S. dollar weakness and what the Federal Reserve chose not do with monetary policy. Now with the FOMC rate decision behind us, the drivers of the EUR/USD should change this coming week as investors shift their focus to the euro zone. We could finally be in a situation where the region's economic outlook matters because the lack of economic data from U.S. puts the focus on a busy euro-zone calendar. To start, this week the Germans are headed for the polls. Angela Merkel is widely expected to win a third term but there is little chance that her party will secure enough seats to avoid forming a coalition. According to the latest polls conducted by ZDF, a local news network, her party s expected to win 40% of the votes and its partners the Free Democrats are expected to win 6% of the votes. Support for the opposition party is estimated to be 27% with their preferred partners the Greens expected to win 9% of the votes. If the Alternative for Germany party, who opposes the euro gets into Parliament, Merkel may be forced to form a grand coalition with the opposition (Social Democrats). This would not be an end of the world scenario because it's the same coalition she governed with in her first term but it could lead to near term weakness for the euro. As the surveys currently stand, a grand coalition can still be avoided.

Monday's trade will begin with some of the most important pieces of data released from the euro zone on a monthly basis -- the flash PMIs. Economists are looking for economic activity to improve which could accelerate gains for the euro. However there's still a lot of uncertainty about the outlook for the region and this makes Monday's PMI report even more important. If the data is strong, the EUR/USD could break 1.36. ECB President Draghi will also be speaking about monetary policy, a hot topic that could trigger volatility for the currency. Later in the week, the German IFO report is scheduled for release and a number of ECB officials will be speaking. We expect to get greater clarity on the outlook for the euro-zone economy and the ECB's monetary policy, which will help investors decide whether EUR/USD deserves its recent gains.

FOMC Officials Keep 2013 Tapering Talk Alive
The Federal Reserve's decision to keep asset purchases on hold this week only resulted in a one-day sell-off for the U.S. dollar. Since then the performance of the greenback has been mixed and Friday, it continues to tread water as policymakers add more confusion to the mix. When the central bank decided to maintain its current bond-buying program they led the market to believe that given a lack of momentum in the U.S. recovery, they could postpone reducing QE until 2014. However based on Friday's comments from FOMC officials, the central bank could be much closer to tapering than Bernanke alluded to on Wednesday. We didn't have to wait for the Fed minutes to get a better sense of the difficulty of the decision because policymakers have been lining up to speak.

According to FOMC voter Bullard, the decision was a close one because tapering "by $10 billion is not a big deal." In other words, the central bank felt that by reducing asset purchases by only $10 billion, the impact would be so nominal that they might as well decide to keep QE policy unchanged to give the economy its best chance of recovery for the next few months. In addition to admitting the decision was a borderline call, Bullard left the door open for tapering in October. After holding policy steady, few investors considered next month as a viable option but Bullard made it clear that they are flexible and could hold a special press conference after the October meeting if needed. Fed President and FOMC voter Esther George was even less dovish -- she flat out admitted that she dissented at the last meeting and criticized the central bank for their disappointing decision. George felt that there is enough progress in jobs and data in general to justify a move and said slow tapering would allow the markets to adjust. She even slammed the central bank for not following through with their signals, saying that it erodes their intent of policy, creating confusion and disconnect.

The main takeaway from Bullard and George's comments Friday is that the Fed is keeping all of their options open and despite Wednesday's decision they are still very close to slowing asset purchases. When the reduction is made, it could be between $15 billion to $25 billion, an amount they feel will put a significant dent into their overall program. So the dialogue about tapering asset purchases this year hasn't ended and in fact economists are divided on whether the first reduction would occur in December or early 2014. We should get more clarity on the FOMC's position over the next week because a number of central bank officials are scheduled to speak. Considering that there's not much in the way of market moving U.S. data next week, their comments will be exceptionally important. We have a few housing market reports, durable goods and revisions to Q2 GDP on calendar and growth between April and June is expected to be revised higher which could help the greenback.

GBP: Fiscal Finances Improve
The British pound ended the day unchanged against the U.S. dollar and euro. Public sector finances improved in the month of August but there was no major impact on sterling. Higher tax receipts helped to lower the deficit. Government borrowing came in at GBP13.2 billion which was in line with expectations while the public sector net cash requirement reported a surplus of GBP3 billion. Since the beginning of the month, sterling enjoyed a very nice rally but in the coming week we could see more profit taking or consolidation. There are only a handful of U.K. data releases on the calendar next week and most of them are second tier. The most significant report will be Q2 GDP figures but this is a final figure and unlike the U.S., no revisions are expected. Next to the New Zealand dollar, we feel that the fundamentals for the U.K. are the most promising and therefore we still expect sterling to outperform other major currencies.

The Ongoing Resilience Of NZD
Of all the major currencies, the New Zealand dollar has done the best job of holding onto its post FOMC gains. This resilience is thanks entirely to the hawkishness of the RBNZ and stronger economic data that supports the notion of tightening next year. Credit card spending continued to rise according to last night's report and on an annualized basis, spending rose by the strongest amount since October 2011. Job advertisements declined slightly but the data can be volatile on a monthly basis. As long as Monday's trade numbers don't show a major deterioration in export activity, the NZD should continue to outperform other major currencies. The Australian and Canadian dollars on the other hand gave back their gains as the U.S. dollar recovered. No economic data was released from Australia and the calendar will be exceptionally quiet this coming week. The Canadian dollar extended its losses on the heels of softer consumer prices. Inflationary pressures stagnated in the month of August with year over year gains slowing to 1.1% from 1.3%. Core prices may be slightly hotter but price pressures are at a minimum right now, which will allow the Bank of Canada to keep monetary policy easy. Canadian retail sales are scheduled for release next week and this report will play a very important role in the outlook for the loonie.

JPY: Abe Considers Ways To Offset Consumption Tax Increase
The Japanese Yen traded higher against most of the major currencies Friday. After having recovered all of its pre-FOMC losses, USD/JPY stabilized in Friday trade. Last night's economic reports were mixed with nationwide department store sales rebounding in August, which should be good for the Yen but Japanese investors also bought 921.6 billion foreign bonds in the week ending on September 13. This is the first time in five weeks that investors were net buyers of bonds and given their previous track record, we firmly believe that the run towards 3% for U.S. 10 year yields played a big role in attracting demand. Talk of how the Abe Administration will offset the imminent consumption tax is gaining traction. While an official decision is not expected until October 1, the Prime Minister and core members of his cabinet have agreed in principle to raise the sales tax from 5 to 8% next April. In order to offset the blow that this could have on the economy, the Nikkei (one of Japan's largest newspapers) reported that the government has decided on economic stimulus measures totaling more than 5 trillion yen. Also, Prime Minister Abe is pushing for a reduction in corporate taxes, which he said is a campaign promise this week. Japan's corporate tax rate is the second highest of OECD nations, right after the U.S.

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