Tuesday's FX: Can You Say 'Reversal'?

It was a day for reversals in the foreign exchange market, with the rally in the EUR/USD and USD/JPY halted by fundamental factors at key technical levels. The sell-off was caused by comments from Japan's Economy Minster who expressed concerns about the speed of Yen weakness. This kicked off a wave of deleveraging that led to selling of EUR/JPY and USD/JPY. Technically, the EUR/USD rally stopped right at 1.34, the 100-week SMA while USD/JPY's rally stopped right below 90. So far the uptrends remain intact because key support levels have not been broken but we are keeping an eye on U.S. yields - if they continue to fall, USD/JPY could tumble along with it.

The U.S. dollar traded higher against all of the major currencies except for the Japanese Yen and despite the abundance of U.S. data, the rally in the Yen was the big story of the day. This holiday shopping season was not nearly as weak as some economists had feared with consumer consumption rising 0.5% in the month of December. If we exclude the impact of the 1.6% drop in gas prices and the volatile spending on autos, retail sales was even stronger, rising 0.6% last month. While the Empire State manufacturing survey dropped to -7.78 in January from -7.3, which was significantly worse than expected and producer prices fell for the third month in a row, consumer spending is the backbone of the U.S. economy and the stronger number overshadowed the weaker reports. It is always encouraging to see steady job growth turn into stronger spending but compared to the third quarter, spending growth in Q4 slowed and this means it will provide less contribution to GDP. Therefore even with the upward surprise in retail sales, the U.S. economic data wasn't exceptionally weak or strong. 2013 FOMC Voter Rosengren spoke Tuesday morning and while he expects growth to accelerate, the Boston Fed President said low inflation and high joblessness warrant stimulus and continued accommodation as long as we are projected to miss on both elements of the dual mandate. He admitted the Fed will eventually need to sell some assets but doesn't expect it to happen for most of this year.

Wednesday will be another busy day for U.S. data with consumer prices, the Treasury International Capital flow and industrial production reports scheduled for release. While these numbers are important, we have our eye on the Federal Reserve's Beige Book report because it provides the most up to date assessment of how the U.S. economy is doing. We know that inflationary pressures are muted and manufacturing activity is anemic so the real question is how consumers and businesses are feeling after Congress reached a deal to avert the Fiscal Cliff.

EUR: Hit By EUR/JPY Selling, Despite Strong Spanish Auction
The euro ended the day lower against the U.S. dollar, after falling victim to EUR/JPY selling in spite of stronger economic data and a solid Spanish bond auction. We can tell by the persistent rally in EUR/CHF that the weakness of the EUR/USD does not reflect increased concerns about Europe. The euro zone's trade surplus increased to 11.0B from 8.2B in the month of November. While this did not have a lasting impact on the euro, stronger trade activity for an export dependent region will alleviate some concerns about slower growth. Sovereign debt risks continue to recede with Spain selling 5.7 Billion EUR worth of 12-18-month notes all below the key 2% mark. According to our colleague Boris Schlossberg, the 12 month paper saw a yield of 1.472% while the 18 month went out at 1.687%. The results were markedly better than the period prior when Spain paid 2.778%, demonstrating renewed investor confidence in Spanish sovereign debt which in turn should continue to lower financing costs for EU periphery and allow the region to recover this year. Euro zone consumer prices are scheduled for release Wednesday and hotter inflation in Germany and France points to a stronger print. Unfortunately EZ CPI is never a huge market mover for the euro. Meanwhile EUR/CHF soared for the fourth straight trading day from a low of 1.2085 to a high of 1.2413. This is the strongest continuous rally that we have seen in the currency pair since September 2011. As we said yesterday, don't expect the Swiss National Bank to stand in the way of the abrupt rally in EUR/CHF as this is exactly what they have wished months for and as long as euro risks do not return and investor confidence continues to improve, the rally can continue. Swiss retail sales are scheduled for release on Wednesday.

GBP: Annualized CPI Growth Eases
The British pound traded lower against the U.S. dollar and euro. U.K. inflation numbers were mixed. Consumer prices, the Bank of England's primary focus increased 0.5% in December. The outcome was in line with expectations and left the annualized pace of growth at 2.7%. However excluding food and energy costs, year over year CPI growth slowed to 2.4 from 2.6% and that is good news for the BoE who wants to see inflation ease gradually. While CPI is still well above the central bank's 2% target, it has come down from its 3% pain threshold. Nonetheless the risk to inflation is still to the upside as utility companies raise prices on their consumers. Producer prices on the other hand declined with input prices falling 0.2% and output prices dropping 0.1% last month. Barring a major disappointment in retail sales this week, the Bank of England will most likely keep monetary policy on hold in the first quarter.

NZD: Comm Dollars Vulnerable To Deleveraging
The Canadian and Australian dollars ended the North American trading session only slightly lower against the U.S. dollar. No economic data was released from Australia but Canadian existing home sales fell at a slower pace in the month of December. Sales of previously owned homes in Canada dropped 0.5% compared to a decline of 1.7% the previous month. Overall the country's housing market remains weak despite low interest rates but according to the report prices increased last month, which is encouraging. New Zealand's housing market is also struggling with prices falling 0.6% and the number of homes sold dropping 23% in December, granted this tends to be very volatile since New Zealand is a small country. Unlike the CAD and AUD, the New Zealand dollar fell sharply on the back of weaker economic data and deleveraging. Australian consumer confidence numbers are scheduled for release this evening along with new motor vehicle sales. With no major reports on the calendar, we expect commodity currencies to continue to take its cue from risk appetite and deleveraging in Yen crosses.

JPY: Amari's Bark Is Bigger Than His Bite
The Japanese Yen experienced its strongest one day rally against the U.S. dollar in the past four months. The 1% decline in USD/JPY drove all of the Yen crosses and even some of the majors lower. The biggest decline was in CHF/JPY, which lost nearly 2% of its value. Over the past few weeks, the one way sell-off in the Yen and the promise of even easier monetary policy caused a surge in demand for Yen funded carry trades. However last night, Japanese Economy Minister Amari's comment about the potential negative aspect of an excessively weak currency triggered a wave of profit taking and deleveraging. Considering that USD/JPY has become extremely overbought, corrections are not surprising but it is important to realize that Amari's bark is bigger than his bite because the Japanese would never stand in the way of Yen weakness especially with their economy at its current state. Yen weakness also goes a long way in achieving Prime Minister Abe's goals of ending deflation and boosting growth. Japanese economic data remains weak with bankruptcies and machine tool orders falling at a faster annualized pace in December. Consumer confidence is due for release this evening along with Domestic Goods Price Index, an inflation measure but we don't expect these reports to show any major improvement in Japan's economy.

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