Currency Market Shifting Focus to Interest Rates on Improving US Fed Outlook

Key Overnight Developments

• Japanese Firms Plan Record Spending Cuts in the Fourth Quarter
• UK House Prices Fall for Second Month, Declines to Continue in 2010
• NZ Service Sector Grows at Fastest Pace in 2 Years as Sales, Orders Rise
• Dollar Drops, Quickly Recovers as Abu Dhabi Promises Dubai Bailout

Critical Levels



The Euro corrected a bit higher after Friday’s sharp selloff, adding 0.3% against USD. The British Pound traded lower, giving up 0.2% against the greenback. The US Dollar dropped sharply after Abu Dhabi said it would offer a $10 billion bailout for Dubai after it came close to default over recent weeks but quickly recovered, trading little changed ahead of the opening bell in Europe. We remain short EURUSD at 1.4881 and short GBPUSD at 1.6648.

Asia Session Highlights



Japan’s Tankan Survey of business confidence offered a mixed outcome for large companies’ fourth-quarter outlook. Conditions in the manufacturing sector continued to improve, albeit at the slowest pace since June, but the service sector that employs over 65% of the labor force turned more pessimistic. Most worryingly, the All Industry Capex gauge that tracks business investment shrank -13.8% from the previous year, a larger drop than economists expected (-11.3%) and the largest one since records began in 1983. On balance, the report seemed to suggest that companies continue to downsize while the boost to manufacturing from global stimulus efforts dissipates, which bodes ill for employment and growth prospects in the world’s second-largest economy.

UK House Prices fell for the second consecutive month according to Righmove, an online listing of for-sale properties, shrinking -2.2% in December after dropping -1.6% in the previous month. Rightmove commercial director Miles Shipside said the recent rebound in prices, which a variety of observers have attributed to shallow supply rather than growing demand, may stall next year as property repossessions boost the number of homes on the market.

New Zealand’s economic data proved broadly positive. The REINZ Housing Price Index advanced to the highest level in nearly two years in November, although the pace of growth slowed with property values rising just 0.2% from the previous month, the least since June. The Performance of Services Index surged to 56.0, showing the sector expanded at the fastest since November 2007. The details of the report were also encouraging: sales surged 10.3% and new orders added 8.5% from the previous month, the biggest gains in at least six months. Stephen Topliss, research head of Business NZ, the firm that compiles the index, said the mood in the service sector has become “unequivocally upbeat”.


Euro Session: What to Expect



Euro Zone Employment figures headline the economic calendar in European hours, although the release is unlikely to prove especially market-moving considering the outcome is likely to have been priced into exchange rates for some time. Indeed, traders have already seen that the jobless rate advanced from 9.3% in the second quarter to 9.63% in the three months through September, which can reasonably be expected to correspond with another decline in the overall employment level. Rounding out the docket, Euro Zone Industrial Production is set to shrink for the first time since April, slipping -0.7% from the previous month in October as the boost to demand from a combined total of nearly $2 trillion in global fiscal stimulus begins to wane.

On balance, the transition in underlying trading dynamics apparently underway in currency markets is likely to be of greatest interest. Indeed, trader’s response to last Friday’s better-than-expected US Retail Sales report was quite telling. The inverse relationship between the US Dollar and equities that had firmly held since last year’s credit crunch dissipated, with both stock prices and the greenback pushing higher. Further still, most major currencies’ (excluding the British Pound) relative performance against USD fell squarely in line with the priced-in yield outlook for the next 12 months. Those currencies looking ahead to significant monetary tightening suffered relatively smaller losses against the greenback, while those with little or no rate hikes on the horizon sank sharply lower.

A similar outcome emerged last week as a wildly better-than-expected US jobs report crossed the wires. On balance, both instances suggest that currency markets are beginning to see the first signs of a decoupling from the risk vs. safety dichotomy that had characterized them over the past two years and moving back towards being driven by the most traditional of fundamental catalysts: interest rates. Indeed, the Federal Reserve typically waits for labor markets to show durable signs of improvement before raising interest rates after a recession, and both the sales and jobs reports encouraged perceptions that this may now happen sooner than previously thought. Overnight index swaps now suggest traders are pricing in the likelihood that Fed will boost rates by 85 basis points over the next 12 months, a gain of nearly 23bps just since Friday.


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