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Fed, ECB Policies That (Should) Matter Most

Fed, ECB Policies That (Should) Matter Most

Kathy Lien, Technical Strategist

The Fed and European Central Bank (ECB) are at opposite ends of the spectrum when it comes to ending their stimulus plans, but given Italy’s political turmoil and other risk factors, the issue is having a minimal impact on EURUSD…for now.

Given all of the problems in Italy, forex traders may be surprised to hear that the best-performing major currency pair is still the EURUSD. There's been no additional clarity on the Italian elections, and if anything, Beppe Grillo's refusal to support Pier Luigi Bersani could put Italy on track for new elections if Bersani fails to form a coalition with Grillo or Silvio Berlusconi.

Prolonged political uncertainty makes Italy a major source of risk for the euro this year. After the sharp selloff in Italian stocks and rise in Italian bond yields, investors appear to have calmed down a bit, with stocks recovering 1.7% and bond yields retreating on Wednesday.

Italy's successful bond auction certainly helped because it indicates that the election results have not completely scared investors away from Italian assets. Eurozone confidence numbers also surprised to the upside, lending support to the currency. However, as long as the makeup and policies of Italy's government are unclear, the euro will have a tough time recapturing 1.33, let alone 1.34 or 1.35.

Investors may be dipping their toes back into the water, but they won't be rushing back into European assets until they know what type of Italian coalition government is formed—if any—and whether new elections will need to be held.

See also: 3 Lingering Questions Weighing Down Major Currencies

The euro also shrugged off comments from European Central Bank (ECB) President MarioDraghi, who reminded us that the central bank is "far from having exit in mind." He said with the Eurozone economy still weak, policy accommodation is needed to stimulate growth. The markets are improving, but inflation is expected to be significantly lower than 2% next year, giving the central bank plenty of room to keep monetary policy easy.

The ECB and the Federal Reserve couldn't be further apart when it comes to exit strategies. In his Congressional testimony, Fed Chairman Ben Bernanke said the central bank will need to start reviewing their exit strategy, while in contrast, ECB President Draghi completely brushed off the idea. These differing views should be bearish for EURUSD, but as we have seen, currency traders are not focused on the issue, and the pair has instead followed US equities higher.

Strong US Data Bolsters Dollar and Risk Appetite

The strong rally in US stocks and improvement in risk appetite eased safe-haven flows out of the greenback and lifted the currency higher against the Japanese yen (JPY). Durable goods orders fell 5.2% in the month of January, but the majority of the decline was in transportation orders because excluding transportation, durable goods rose 1.9%, which was the strongest rise since October 2011.

Pending home sales also beat expectations, rising 4.5% in the month of January. The data is consistent with what we have seen in new home sales and indicative of a steady recovery in the housing market.

Even Bernanke believes that the housing market has hit a bottom and is currently recovering. On day two of his testimony before Congress, the Fed Chairman sounded a bit more optimistic about the economy. In addition to his housing market comments, he also said that the rise in interest rates is "indicative of a stronger recovery." However, he warned that getting back to a 6% unemployment rate could take another three years.

When asked about an exit, Bernanke said the central bank will have to start reviewing their strategy, which may suggest that it has not completely ruled out the idea of tapering asset purchases. This was also our main takeaway from day 1 of his testimony.

Revisions to Q4 US GDP are due for release on Thursday, along with jobless claims and the Chicago PMI report. Economists are looking for a sharp upward revision to fourth quarter growth (from -0.1% to +0.5%), and if they are right, the dollar should rally.

Meanwhile, the Sequestration is scheduled to happen at the end of the week, and so far, it seems that the House and Senate have yet to reach an agreement. According to Fitch, "implementation of the spending cuts—sequester—and government shutdown would not prompt a negative rating action," however, "failure to raise the debt ceiling in a timely fashion could prompt a review and likely downgrade of the US debt rating."

Beleaguered UK Economy Posts Surprise Expansion

The British pound (GBP) weakened against the euro and rebounded against the US dollar. On a headline basis, GDP in the fourth quarter was left unrevised at 0.3%. However, on an annualized basis, GDP was revised up to 0.3% from 0%.

In other words, instead of stagnating in 2012, the UK economy expanded by 0.3%. This albeit small improvement came primarily from the construction sector, as manufacturing output was revised up slightly and service output was revised lower.

Overall, the data confirms that the recovery in the UK economy is very sluggish and more monetary stimulus is needed if the government wants to reinvigorate activity. We knew where Bank of England (BoE) markets director PaulFisher stood before he delivered his speech yesterday, but monetary policy committee member Charlie Bean, on the other hand, was more of a centrist. In his speech, Bean said the UK recovery is likely to remain "somewhat subdued," but "there's danger of expecting too much from monetary policy."

The only data due from the UK on Thursday is consumer confidence, and given the drop in the CBI retail trade index, we are not expecting any improvement on that front.

The Critical Level to Watch in AUDUSD

The Australian dollar (AUD) recovered nicely after dropping below 1.02 against the greenback for the first time in four months. While 1.0200 is an important round number, the real support level for AUDUSD is 1.0148, a level that it tested but failed to break on numerous occasions over the past seven months.

If AUDUSD closes below 1.0148, there's a very good chance that it could break below parity. The latest round of AUD weakness was triggered by weaker economic data and S&P's comment about Australia's credit rating. While S&P said Australia has "several robust credit fundamentals" to support its AAA rating, their comment that Australia faced the prospect of a downgrade if demand from China slowed materially, or if the country's housing sector saw a sharp fall in prices, was enough to send investors rushing out of the AUD.

See also: World’s Weakest Currency…And It’s Not the Euro

In terms of data, construction showed a surprising contraction of -0.1% versus 1.5% eyed.

The New Zealand dollar (NZD) stabilized after surprisingly weak trade numbers. Australian new home sales and New Zealand business confidence numbers are due for release this evening.

After rallying for seven straight trading days, USDCAD is showing signs of exhaustion. We see this as nothing more than a technical move since there has been no economic data out of Canada. Current account, raw materials, and industrial product prices are due for release on Thursday. Recent improvement in trade points to the possibility of a stronger report, which could trigger a deeper reversal in USDCAD.

By Kathy Lien of BK Asset Management

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.