What's Behind The Dollar's Rally?

The fact that the U.S. dollar outperformed all of the major currencies today except for the Japanese Yen and the Swiss Franc - two other safe haven / funding currencies tell us deleveraging and profit taking is behind the strength of the greenback. A number of U.S. economic reports were released this week and more is expected on Thursday but none of these reports including retail sales had a lasting impact on the dollar and that's because they did not improve or deteriorate enough to change the Federal Reserve's views on monetary policy. The economy is improving gradually but the pace of growth is still too slow and unemployment is too high for the central bank to seriously consider phasing out asset purchases. The same was reported in the Fed's Beige Book, which found labor market conditions, wages and inflation virtually unchanged. House prices increased but manufacturers were generally optimistic and overall, the regional banks reported "modest to moderate economic growth."

Housing starts, building permits, jobless claims and the Philadelphia Fed manufacturing index are scheduled for release Thursday and we expect these reports to paint a consistent story about the performance of the U.S. economy. That is the housing and labor markets are recovering gradually while the momentum in the manufacturing sector has slowed slightly. Consumer prices were released this morning and the data continues to show muted inflationary pressures. CPI was flat in the month of December after falling 0.3% in November. Core prices which exclude volatile food and energy costs increased a mere 0.1%. On an annualized basis, CPI growth eased to 1.7% from 1.8%. The lack of inflation allows the central bank to keep monetary policy extremely easy. The Treasury International Capital Flow report, a measure of demand for U.S. dollars showed foreigners buying $52.3B worth of long term Treasuries, which is encouraging considering it, was during the height of the Fiscal Cliff uncertainty. Industrial production increased 0.3%, in line with expectations while the NAHB Housing Market Index, a measure of builder confidence held steady at 47.

What we have learned over the past 72 hours is that overstretched trends in currencies make them especially vulnerable to comments from central bankers and any cause for uncertainty.

EUR: Supported By Euro Comments But Germany Cuts Growth Forecast
The euro ended the day only slightly lower against the U.S. dollar thanks to supportive comments from European policymakers. Yesterday, Eurogroup President Juncker's comment that the euro was at dangerously high levels sent the EUR/USD tumbling and raised concerns about whether the Europeans are getting antsy about the appreciation in their currency. However comments from ECB member Nowotny and Germany's economy minister suggests that the concern may be Juncker's alone. Nowotny said the currency was not a major concern and the Germans said the euro is not overvalued. We should only be worried when ECB President Draghi tries to talk down the currency. In the meantime, aside from EUR/JPY selling, grim economic forecasts for German growth this year also weighed on the euro. The Federal Statistics office of the German government cut its 2013 GDP forecast for the euro zone's largest economy by more than 50%. Back in October, the government predicted 1% GDP growth this year but they now believe that the economy will expand by only 0.4%, down from a revised forecast of 0.7% growth in 2012. The slowdown in the rest of the region has taken a big toll on German exports and with growth in countries such as Spain, Italy, France and the U.K. expected to remain weak this year, the German government doesn't anticipate a major rebound. Nonetheless, weaker growth did not stop Germany from holding another successful bond auction as bids were well above last year's average. Meanwhile for the first time in five trading days, EUR/CHF did not extend its gains despite a smaller than anticipated increase in retail sales. Consumer spending grew 2.9% in the month of November, up from 2.7% in October -- economists were looking for a stronger 3.4% rise.

GBP: PM Cameron Rejects EU Referendum
Next to the Japanese Yen, the British pound appears to be the worst performing currency. Sterling lost value against the U.S. dollar for the fourth trading day in a row and is hovering near nine month highs against the euro. No U.K. economic data was released overnight and nothing substantial is expected until Friday but as we have warned, sterling is being punished as concerns in Europe shift from the euro zone to the U.K. Prime Minister Cameron rejected calls for a referendum on the country's European Union membership. With the increased policy changes happening in the E.U., many lawmakers in the U.K. are growing concerned about the country's close relationship with the union. Cameron believes the U.K. is a fundamental component of the E.U. and has benefitted significantly over the years from being part of the Union but the U.K.'s role in the EU should be renegotiated and put to a public vote. On Friday, the Prime Minister will outline his views on how Britain's relationship with the EU should develop as the 17 members of the euro-zone plan a closer fiscal union.

CAD: Finance Minister Says 'No Additional Stimulus Needed'
The Canadian dollar ended the day slightly lower against the greenback after Finance Minister Flaherty said Aboriginal protests may hurt the Canadian economy. Serious traffic blockages are expected across the nation at some of the busiest border crossings as people protest against changes to Bill-C 45, a budget bill that directly affects first nation communities. Any impact should be only temporary as the protests are not expected to extend for days. What's more important was Flaherty's belief that no additional stimulus is needed. Modest growth should be sufficient to balance Canada's budget and if anything, the housing market is in danger of overheating. The Australian and New Zealand dollars ended the day slightly higher. Consumer confidence rebounded in January according to a survey conducted by Westpac and we're hoping stronger confidence means steadier labor market conditions. Australian employment numbers are scheduled for release this evening and the unemployment rate is expected to increase from 5.2% to 5.4%. If job growth exceeds expectations, the AUD/USD could test 1.06 but if Australia reports job losses in December, the AUD/USD could slip to 1.05.

JPY: Why Rapid Yen Weakness Is Worrying Policymakers
The Japanese Yen may have traded higher against all of the major currencies for the second day in a row, but it ended the day well off its highs. While the Japanese government wants a weaker currency, recent comments from Japanese officials suggest that they did not anticipate such a rapid and aggressive sell-off in the Yen. Last night, LDP Secretary General Ishiba added to Economy Minister Amari's concerns by saying that yen weakness would affect some industries negatively. There's no question that Japanese companies who buy components from overseas will suffer from yen weakness but even companies who rely on exports have complained that global investors could lose confidence in Japan and interest rates could soar if the Yen weakens too rapidly. However at the end of the day, Japan will still benefit more from a weak Yen than a strong one but what Japanese officials are trying to tell us is that regardless of the fundamentals, rapid movements in the foreign exchange market can cause problems for the economy. The buzz on the street is that the Japanese government wants USD/JPY to remain between 85-90, a level that Ishiba discussed last month.

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