US Dollar Extends its Advance as Speculative Interests Unwind and Confidence Improves

US Dollar Extends its Advance as Speculative Interests Unwind and Confidence Improves
The US dollar rallied throughout Tuesday’s Asian and European sessions; but the drive wouldn’t hold through the US trading hours. Considering this late-day tempering and revived correlations across the various markets, it was rather easy to spot the influence of risk appetite in the greenback’s activity. This morning, risk aversion was revived by a series of events that would carry considerable weight for the global financial markets. Looking suspiciously like the catalyst for last week’s bearish reversal; the media reported that Chinese banks had taken steps to halt or limit lending in Shanghai – a definitive step towards stifling the steady and aggressive build in speculative interests. From speculative interests to financial concerns, investors were put on the defensive when the S&P downgraded the credit outlook for Japan (the world’s second largest economy) due to the government’s lack of a plan for reining in the national deficit. Investor anxiety was further carried over into the European session by a downgrade in the outlook for Ireland’s banks and the excessive yield the Greece government bond sale had to promise in order to attract enough attention to cover the issue. Momentum was building for another prominent wave in risk aversion heading into the New York open; but the early strength in the US equities would ensure the next step in safety flows (and rally for the dollar) wouldn’t happen.

For macro event risk, the day’s economic calendar was fuel but ultimately lacking in market-moving potential. The top release for the session was the Consumer Confidence survey for January. Unlike the advanced University of Michigan report for the same period, the Conference Board’s reading bested expectations by a wide margin. In fact, the 55.9 reading was the high for the series since September 2008. Furthermore, the outlook component of the report would hit a 27-month high owing largely to the improvement in employment trends. On the other hand, caution is still warranted considering the Present Situation reading just ticked up from a 26-year low. Among the other notable releases, two home value reports bolstered recovery forecasts for the battered sector. The FHFA’s House Price Index for November jumped 0.7 percent and the S&P/CaseShiller Composite printed the mildest pace of year-over-year contraction in home prices since September 2007. Altogether, these indicators are meaningful and necessary to fuel the economy’s steady recovery; but for immediate impact and volatility, the market is awaiting the bigger economic releases due later this week.

Over the next 24 hours, rate watchers will be tuned in to the FOMC rate decision scheduled for release at 2:15 PM EST. The market is uniform in its expectations for no change to the benchmark lending rate; but there is still room for surprise and market volatility from this event. First of all, commentary can offer clues to the timing for the eventual return to rate hikes – though updated forecasts for the economy and inflation may not come until the March meeting. In the meantime, Fed Fund futures show expectations for the first quarter point rate hike doesn’t breech the 50-percent mark until September. More sensitive to expectations (and therefore more useful to traders), the Credit Suisse overnight index swaps are pricing in 64 basis points worth of hikes through the next 12 months – the least most dovish forecast since December 11th. Another subject to watch for is the possibility that the Fed Funds rate could be replaced or supplemented by the interest rate paid on excess reserves. This would be a dramatic change and would require serious changes for the current system; but such a move has been discussed on a number of occasions and it is not so farfetched given the current, politically-charged environment.

Related: Discuss the US Dollar in the DailyFX Forum, US Dollar Rally Will Depend on Steady Risk Aversion, Dow Losses

British Pound Tumbles after Data shows UK’s Recovery Weaker than Expected
The honors of top event risk would go to the British pound this morning – for better or worse. The United Kingdom officially recovery from its record-breaking recession (at least until revisions are released) with an advanced 4Q GDP reading of 0.1 percent growth.  However, all intents and purposes; this indicator was a notable disappointment for sterling traders. Official forecasts were calling for a 0.4 percent pick up that would have better positioned the economy for a recovery. As it is, the world power is proving itself to be a consistent laggard to its G7 peers. Further dampening the outlook; the 3.2 percent contraction on a year-over-year basis stands as proof that the recovery will come at far more gradual pace than the US, Japan or Euro Zone. Looking into this indicators breakdown, component data revealed the service sector (accounting for approximately 70 percent of overall growth) rose 0.1 percent. Along with a notable 0.4 percent increase in manufacturing, these sectors were able to offset the stagnant financial and construction figures. All in all, data like this will make for a tough election cycle.

Related: Discuss the British Pound in the DailyFX Forum, British Pound Extends Decline as 4Q GDP Disappoints

Euro can’t Translate Strong Business Sentiment and Successful Greek Bond Sale into Gains
After adjusting for the influences of risk appetite; the euro found a relatively even playing field for event risk Tuesday. The only notable piece of event risk on the docket was the German IFO business confidence survey for January. The headline Business Climate reading hit an 18-month high of 95.8, adding to the outlook for the economy to gradually improve with time. Looking deeper into the breakdown, current assessment figure rose to a 13-month high while expectations led the day by hitting levels not seen since July of 2007 (pre-crisis). Alone, this data could have leveraged a little more influence over the euro; but the region’s financial health would come into play again. In the headlines, Standard & Poor’s downgraded the credit rating of Irish banks; and while Greece was able to auction 8 billion euros in debt, it had to do so at very high rates.

Japanese Yen: Why Would the Currency Rally after the Nation’s Credit Outlook is Downgraded?
Considering risk aversion was in full swing in the early morning hours of Tuesday’s session, it isn’t a surprise that the Japanese yen rallied across the board. However, considering Standard & Poor’s downgraded the nation’s credit outlook and the BoJ said it will maintain an “extremely accommodative” position to fight deflation; we have to question the currency’s position as a safe haven. In fact, the currency isn’t a safe haven. It is a source of funding. As investor sentiment deteriorates from the 2009 build up, we aren’t seeing a flight to safety with the yen; rather we are seeing cheap funds that were borrowed in the Japan to fund carry positions are being repatriated, thereby boosting the currency.

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Written by: John Kicklighter, Currency Strategist for DailyFX.com
E-mail: jkicklighter@dailyfx.com