US Dollar, Japanese Yen Linked Once Again as US Consumer Confidence Decline Triggers Risk Aversion
The US dollar and Japanese yen dominated on Friday as disappointing US economic data triggered declines in FX carry trades and equities amidst broad-based “flight to safety.” The most market-moving report was the preliminary reading of the University of Michigan’s consumer confidence survey, which surprisingly fell to a 5-month low of 63.2 in August from 66.0. A breakdown of the survey shows that sentiment on current conditions soured much faster than the economic outlook, suggesting that optimism reflected in last Friday’s US non-farm payrolls report was misleading. Furthermore, the survey showed that inflation expectations for 1-year and 5-years ahead eased back to 2.8 percent and 2.9 percent, respectively, and the latest US consumer price index (CPI) results indicate that expectations could fall even further. Headline CPI went unchanged during the month of July while the annual rate plunged 2.1 percent, the most since 1950, as most subcomponents fell, led by food, energy, and housing.

The one bright spot in all of the day’s US news was industrial production, which rose 0.5 percent in July due primarily to a surge in motor vehicle output. This is similar to what we saw in ISM manufacturing for the same period and adds to evidence that some of the only improvements in the economy, such as car production and housing sales, are the result of the US fiscal stimulus plan, including the “cash for clunkers” program and the $8000 tax credit for some new homebuyers. That said, the impact of these programs will not last forever, and a lasting US economic recovery may not be possible until demand for other consumer goods improves, which will be difficult in the face of rising unemployment and the shift away from spending via credit to increased saving.

Looking ahead to next week, Japan's Cabinet Office will release preliminary growth readings on August 16, and after four straight quarters of contraction and a record drop in GDP during Q1, the results could offer a boost to risk appetite. Indeed, improvement in foreign demand during Q2 has helped lift export demand, and may ultimately be the driving force behind an expected 3.9 percent annualized increase in GDP, following a record drop of 14.2 percent in Q1. Consumer spending, however, may prove to be a drag on growth as wages have fallen amidst mounting job losses. All told, FX traders may see a brief fundamental response from the Japanese yen following the release of Q2 GDP, where positive news pushes the currency higher and negative results lead the currency lower. As European traders start to come in to play, however, risk trends may resume their place as the primary driver of price action.

Related Article: Risk Appetite Hits New Highs For the Year, How High Can It Go?

Euro Down as Euro-zone CPI Falls to Record Low of -0.7%
The euro finally broke down from its consolidation below 1.4300 as the US dollar rallied across the majors. European data certainly didn’t work in favor of euro strength either, as the Euro-zone consumer price index (CPI) fell more than previously expected. Indeed, CPI was initially anticipated to drop by 0.6 percent, but the final reading showed a record decline of 0.7 in July from a year earlier. Looking ahead to August 18, a steady rally in European equities throughout July to the highest levels since Q3 2008 is likely to underpin the case for a rise in German investor sentiment for the month of August. The ZEW survey on the economic outlook is forecast to rise to a more than 3-year high of 45 from 39.5, while sentiment on current conditions is projected to edge up to 7-month high of -85.5 from -89.3. Surprisingly strong results could lead the euro to gain following the news on a very short-term basis, but disappointing data would likely have a greater impact, and could trigger sharp declines in the currency.

British Pound Closes Above Key Support vs. US Dollar, Japanese Yen - UK CPI Next Week
The British pound remained fairly range bound on Friday, as GBPJPY closed above support at 156.00 and GBPUSD remained contained to 1.6485-1.6600. There was no UK data on hand, but this will change on August 18 as the UK’s consumer price index (CPI) reading for the month of July is expected to fall for the first time in six months at a rate of -0.3 percent. This may lead the annual rate of growth, which is more closely watched by the Bank of England, is forecasted to fall to 1.5 percent, the lowest since November 2004, from 1.8 percent, keeping inflation within the central bank’s acceptable range of 1 percent - 3 percent, but below their 2 percent target. If CPI falls more than projected, the British pound could pull back sharply as the markets will anticipate that the BOE will expand their quantitative easing efforts even further before year-end. On the other hand, if CPI holds strong, the currency could rally in response.

New Zealand Dollar Gives Up Post-NZ Retail Sales Gains as Carry Trades Plunge
The New Zealand dollar gained overnight and throughout European trading after New Zealand retail sales (adjusted for inflation) rose more than anticipated by 0.4 percent in during Q3, the first increase in seven quarters, suggesting that consumers are helping to lead the way to economic recovery in the nation. The data also led the markets to price in greater rate increases by the Reserve Bank of New Zealand down the road, as Credit Suisse overnight index swaps call for 107 basis points worth of hikes over the next 12 months, up from 96 basis points on Wednesday. However, the New Zealand dollar subsequently ended the day down more than 1 percent against the Japanese yen as broad-based risk aversion struck during US trading, taking FX carry trades lower.

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Written by: Terri Belkas, Currency Strategist for DailyFX.com
E-mail: tbelkas@dailyfx.com