USD: Unfazed By GDP Or The Fed

It was a busy day in the FX market but the U.S. dollar was completely unfazed by the surprise decline in Q4 GDP growth and the slightly more pessimistic comments from the FOMC. As expected, the Federal Reserve left monetary policy unchanged and FOMC voter Esther George replaced Lacker as the one dissenting member of the central bank voting against keeping monetary policy easy. She expressed concerns "that the continued high level of monetary accommodation increased the risks of future economic and financial imbalances and, over time, could cause an increase in long-term inflation expectations." This was not a big surprise since George is known as a hawk but what was surprising was that the Fed's tweaks to the FOMC statement made it sound slightly more dovish. The Fed noted that the strains in the global market have eased but said, "economic activity paused in recent months" due to weather-related disruptions and other transitory factors. They also continue to see downside risks to the economic outlook. Yet the impact on the U.S. dollar was limited because investors realized that the Fed's stance hasn't changed at all - they plan to keep interest rates low and their $85 billion per month asset purchase program intact for the time being because there has not been enough consistent improvements in the economy to warrant a change in plans.

The 0.1% contraction in U.S. GDP growth during the fourth quarter certainly didn't make them any more optimistic. This was the first time that growth declined since the second quarter of 2009. The problem was defense spending which fell a whopping 22% last quarter but while GDP was a headline shocker, the sell-off in USD/JPY was limited because the details were not nearly as bad. Disposable income hit its highest level since Q2 of 2008 while residential investment rose 11.9%, the strongest gain since 1992. Consumer spending also rose 2.2%, which was stronger than expected and up from 1.6% in Q3. As a result, we don't expect the Federal Reserve who will make its monetary policy announcement later this afternoon to be overly concerned about the contraction in GDP growth. The chance that the contraction in Q4 will turn into a recession in 2013 is extremely low especially because spending, which is the most important component of GDP increased. The U.S. economy is still on track for a continued recovery this year. The ADP employment report also beat expectations, rising to 192k from 185k in January. ADP is not the best leading indicator for non-farm payrolls but it can be useful directionally. Jobless claims and the Challenger layoff reports are due for release Thursday along with personal income and personal spending. Since the recent drop in claims have been attributed to seasonal factors, investors will be watching closely to see if claims finally normalize.

EUR: Above 1.35 For The First Time Since November 2011
The EUR/USD broke above 1.35 for the first time in 14 months and after the move occurred, the rally extended as high as 1.3587. With relative economic fundamentals driving FX flows, better than expected euro zone economic data and weaker U.S. data propelled the EUR/USD higher. Euro zone consumer confidence increased more than expected in the month of January. The index rose to 89.2 from 87.8 in December to its highest level since June. While businesses were far more optimistic than consumers, the fact that optimism improved at all was enough to drive the euro higher. German retail sales, unemployment and inflation numbers are scheduled for release Thursday along with French consumer spending and producer prices. Further gains in the euro will hinge out the outcome of these reports. According to Markit Economics, consumer spending in Germany hit a seven-month high, which bodes well for the retail sales report but unemployment could climb because greater job losses were seen in the manufacturing sector. It may be a tough call but given the bullish bias in the euro, as long as there is a small improvement in both reports or very little deterioration the EUR/USD could sustain its gains.

NZD Soars On Optimism From The RBNZ
The New Zealand and Australian dollars traded lower against the greenback, Wednesday, despite optimistic comments from the Reserve Bank of New Zealand. While the RBNZ left interest rates unchanged at a record low of 2.5%, central bank governor Wheeler said domestic data suggests GDP growth is recovering and he expects growth to strength domestically and internationally in 2013. His concerns about household credit growth and house price inflation reflects the consequences of low interest rates. If these become a greater problem for New Zealand's economy, the RBNZ may need to start to consider raising interest rates. Wheeler also attributed low inflation to an overvalued currency but based on prior comments, his willingness to intervene is low. While these optimistic comments did not turn the day's losses into gains for the NZD/USD, it helped the currency pair recover a large part of its earlier losses and should fuel gains on Thursday. With no major economic reports released from Australia, the AUD/USD remains under pressure. The CAD on the other hand ended the day unchanged against the greenback. November GDP numbers are due for release Thursday and while economists are looking for faster growth, we believe that the dive in retail sales and rise in Canada's trade deficit could translate into a downside surprise.

GBP: Drops To 13-Month Low Against The EUR
The British pound may have rebounded against the U.S. dollar but it dropped to its lowest against the euro in 13 months. Better than expected U.K. housing market numbers had only a limited impact on the currency. Mortgage approvals rose by 55.8K in the month of December while net consumer credit increased by 0.6B, up from 0.1B the previous month. While this improvement is certainly good news, lending and borrowing are still way below pre-crisis levels. The data also shows that relatively limited uptake in the government's Funding for Lending Scheme. Nationwide house prices are due for release along with consumer confidence. House prices are expected to increase slightly, which would be consistent with a gradual recovery in the housing market. Consumer confidence is also expected to improve slightly which is almost a necessity if the U.K. economy wants to have any hope of recovering in the first quarter. We don't expect the GBP/USD to extend its gains much beyond its current levels but EUR/GBP has cleared its 200-week SMA and while 86 cents is a level of resistance, the more significant point of contention is 88 cents.

JPY: Rally In Nikkei Supports Uptrend In USD/JPY
Although USD/JPY rose to a fresh 2.5-year high, Wednesday, the new milestone was only 15 pips higher than the level reached on Monday. Other Yen crosses such as EUR/JPY and CHF/JPY broke previous highs in a far more meaningful manner but that does not draw away from the fact that the uptrend in USD/JPY remains intact. The 2% rally in the Nikkei and the continuous rise in U.S. 10-year yields are providing support for USD/JPY. There has long been a positive correlation between USD/JPY and the Japanese stock market, which rose to a 33-month high overnight. Japanese data fell short of expectations with retail sales growing a mere 0.1% in December, up from a downwardly revised decline of 0.1%. As a result, year over year retail trade growth slowed from 1.2% to 0.4%. Disappointments in Japanese data are exactly what USD/JPY needs to push higher. Wednesday night's manufacturing PMI and industrial production reports will be particularly important because they will show how much Yen weakness helped the economy in the month of December. Based on the forecasts for industrial production, economists are looking for a nice rebound in manufacturing activity.

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