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The US Dollar may decline in European trade as US equity index futures trade 0.6% higher ahead of the opening bell, pointing to a rebound in risk appetite that could weigh on the safety-linked greenback.

Key Overnight Developments

• New Zealand Dollar Little Changed After RBNZ Rate Decision
• Japanese Retail Sales Disappoint as Consumer Confidence Flounders

Critical Levels



The Euro is little changed heading into the European session after prices retraced nearly all of the drop below 1.40 seen in early overnight trade. The British Pound has also yielded an effectively flat result, reversing lower late into Asian trading after testing as high as 1.6229 against the greenback. We remain short EURUSD at 1.4881.


Asia Session Highlights



The Reserve Bank of New Zealand kept benchmark interest rates unchanged at 2.5% as expected. RBNZ Governor Alan Bollard said annual inflation is expected to track comfortably within the target band over the medium term, reiterating that the bank expects to begin removing policy stimulus around the middle of 2010. The reaction from the currency markets was understandably muted considering the outcome offered no significant changes in policy expectations.

Japan’s Retail Trade report showed sales fell much more than economists expected in December, slipping -1.2% versus calls for a -0.2% decline. In annual terms, sales fell -0.3%, disappointing expectations forecasting the first increase 15 months. The outcome follows a report last week that showed consumer confidence fell for the second consecutive month in December amid expectations of deepening unemployment.

Are the US and global economies developing a speculative bubble? Just a year ago, investors and policy makers were still reeling from the fallout of the worst financial crisis in modern history. Today, though growth projections are reserved and yield expectations are far below the levels seen through the boom years, the Dow is 60 percent above its 2009 lows. This is a side effect of the world’s governments laying down a safety net for speculators in the form of policy and encouraging risk taking through unprecedented injections of stimulus. Interest rates near recent-record lows have opened the doors to financing and leverage; and market participants are happy to recover some of the wealth lost through the preceding crisis. However, a factor that has been ignored for too long through the bullish rally is that this market cultivation is temporary. Eventually, the government has to withdrawal its support and the market will have to stand on its own weight. Considering the sharp rally in the dollar and drop in risk-sensitive markets today, this eventuality can no longer be ignored. And, while this particular spike in volatility doesn’t necessarily mark the turning point for speculation; it nonetheless speaks to the doubts that lie just beneath the surface. Should a move to fairly value capital markets develop, the dollar will be a primary benefactor as a primary source of funding behind the carry trade build up. Furthermore, when the US and Japanese 3-month Libor rate finally flip in the dollar’s favor, the greenback won’t have to depend on risk alone.

Recently-choppy US Dollar price action has made for similarly directionless shifts in forex sentiment, and we believe that the US Dollar is likely to continue range-trading against the Euro. Strong rallies in the British Pound, on the other hand, seem likely to continue given strongly one-sided crowd positioning and give us reason to believe that the GBP will continue to gain against the USD and Japanese Yen. We see similarly extreme crowd sentiment in the Canadian Dollar and accordingly call for further CAD strength against its US namesake (USDCAD losses), while forecasts likewise point to further Swiss Franc rallies against the Euro and US Dollar. Watch our twice-a-day updates on DailyFX+ for more up-to-date SSI positioning data.

The near-term trajectory of the Japanese Yen against the US Dollar is veiled in uncertainty after mixed cues from December’s US jobs report jumbled relative yield expectations between Japan and America.

Japan’s savings rate is high relative to other developed countries, reflecting the expense of living on an island with limited space and scarce home-grown resources. This translates into Japanese investors’ preference for safe, liquid assets that offer stable income over a long period of time. Typically, this means a choice between either US or domestic government debt, with the favored asset determined by the yield difference between US and Japanese bonds. These underlying capital flows are the dominant driver behind USDJPY, with the pair now nearly 84% correlated with the spread between the yields on the two countries’ 10-year Treasury notes.

The outlook for US interest rates took a hit after December’s labor market figures fell short of expectations, showing the world’s largest economy shed 85,000 jobs versus forecasts of a flat result. However, the outcome was not without a silver lining as November’s numbers were revised higher to reflect a 4,000 jobs gain versus the originally reported 11,000 loss, which amounts to the first positive outcome in two years. Still, the market’s first reaction was that of disappointment as the 10-year yield spread moved by nearly a full basis point in favor of Japanese notes while a Credit Suisse gauge tracking the market’s priced-in US interest rate outlook for the next 12 months dropped to a four-week low.

Meanwhile, short-term interest rates seem to be telling a different story. Much of the Dollar’s weakness through 2009 was attributed to the fact that the cost short-term (3-month) borrowing in Japanese Yen surpassed that of the greenback for the first time since 1995, leading to the widespread proliferation of the short-USD carry trade. As of Friday, this yield advantage has narrowed to the smallest since August, suggesting the Yen is well on its way to reclaiming the dubious honor of the most favored funding currency.

On balance, it is unclear which one of these relationships will prove dominant in the near term. If the initial reaction seen in the 10-year bond spread sees follow-through in the week ahead, USDJPY is set to decline. Alternatively, if short-term rates take center stage that should encourage a repositioning of carry trade portfolios away from a short-USD to a short-JPY bias, leading USDJPY higher.

The Euro finished the week modestly higher against the US Dollar despite a fairly disappointing string of European economic data. Soft Purchasing Managers Index survey results and disappointing Retail Sales data may have normally been enough to sink the Euro against its US counterpart, but likewise disappointing US Nonfarm Payrolls results left the EURUSD higher. Euro Zone consumers spent 1.2 percent less on retail goods through the month of November—substantively worse than consensus forecasts of no change. The true fireworks may nonetheless wait until the coming week’s key European Central Bank Interest Rate Decision. Relatively aggressive market interest rate forecasts suggest that unexpectedly dovish ECB rhetoric may force substantive Euro pullbacks and it will be critical to monitor any and all commentary from the central bank.

The Euro’s relatively narrow trading range against the US Dollar suggests that markets have reached an impasse. On the one hand, fairly steady improvements in US economic data and a strong surge in US Dollar-long positions suggests that the tides may have turned in the Greenback’s favor. On the other, Euro Zone data has likewise generally improved and the longer-term trend favors continued Euro appreciation against the US currency. A key question in traders’ minds is simple: which major central bank will begin tightening monetary policy the soonest?

Overnight Index Swaps show that interest rate speculators and hedgers predict that the ECB will raise rates by a cumulative 99 basis points in the coming 12 months—noticeably more than expectations of 77bp in Fed rate moves. Relatively lofty expectations may nonetheless be put to the test by the upcoming ECB meeting. Though the bank will almost certainly leave rates unchanged, any suggestions that they may soon raise rates could easily force Euro volatility against the US Dollar and other counterparts. Considerably more dovish rhetoric would likely force the biggest moves, however; comparatively lofty Euro rate expectations leave it at clear risk of pullback on any disappointments.

The Euro Zone economic calendar is otherwise devoid of historically market-moving economic releases, and it will be far more important to watch market positioning and sentiment through various measures. As we wrote recently, CFTC Commitment of Traders data shows that large speculators remain the most net-short EUR/USD since it bottomed in late 2008. Whether or not history repeats itself may be a question of key fundamental developments out of the world’s largest economies.

Another exciting session of trade in Europe with the Euro selling off like wildfire early on following ECB Stark comments that the EU would not save Greece. Stops below 1.4300 in Eur/Usd were tripped, with the pair trading down to 1.4285 before finally finding some solid support.

MORNING SLICES

FUNDYS

Another exciting session of trade in Europe with the Euro selling off like wildfire early on following ECB Stark comments that the EU would not save Greece. Stops below 1.4300 in Eur/Usd were tripped, with the pair trading down to 1.4285 before finally finding some solid support. The move appeared to be more than an overreaction with some swift buying reversing market direction and taking the pair back to fresh session highs towards 1.4400. Comments from the Greek FinMin that all would be fine also helped to reinfuse appetite for the Euro.

Relative Performance Versus USD on Wednesday (As of 10:45GMT) –

1) AUSSIE +0.20%
2) CAD +0.13%
3) SWISSIE +0.06%
4) STERLING +0.03%
5) EURO -0.01%
6) KIWI -0.22%
7) YEN -0.80%

Although the Pound had been bid on the day, there were many looking to sell the single currency after Pimco came out for the second time in two days to warn of the high risk of Britain losing its coveted triple A rating. Also on the ratings front, Fitch was seen demoting Iceland’s ratings which did not help to bolster investor risk appetite. More broad comments on the USD on Wedensday with the UAE coming out and reaffirming that it would maintain its peg to the Greenback. The PBOC was out with monetary policy report and there were no shockers after the Chinese central bank said that it would maintain an appropriately loose monetary policy to support the ongoing recovery.

On the data front, releases were on the whole disappointing with German and Eurozone services PMI coming in weaker, while Eurozone PPI was softer and Eurozone industrial new orders were well below expectation. UK services PMI was also released and managed to be the standout after coming in right on consensus.

Looking ahead, mortgage applications are due at 12:00GMT, followed by Challenger job cuts at 12:30GMT and ADP employment (-75k expected) at 13:15GMT. ISM non-manufacturing (50.5 expected) caps things off at 15:00GMT. US equity futures point to a softer open, while oil is flat and gold is slightly bid.

TECHS

EUR/USD: While longer-term and medium-term technicals now warn of a major shift in the structure, which favors additional USD gains, shorter-term technicals are stretched, with the daily RSI in the process of recovering from below 30. Remarkably, the daily RSI in the major had not been below 30 since October of 2008. While this development reaffirms the trend shift into the USDs favor, the shorter-term horizon now warns that we could see more of a bounce over the coming days to allow for some inter-day oversold technical readings to unwind. The risks from here are potentially for a bounce back towards the 1.4625 area before considering a fresh downside extension below the 200-Day SMA.

USD/JPY: Despite the latest bounce, the pair still remains confined to a very strong downtrend and any rallies are seen limited, in favor of a bearish resumption. Look for a lower top to now carve out by 93.20 ahead of the next drop back below key short-term support by 91.00 over the coming sessions. It is however worth noting that the market has broken back above the daily Ichimoku to potentially warn of a shift in the structure. But moves above the Ichimoku in recent attempts have proved fleeting. A break back above 93.20 will now be required to force a shift in our bias.

GBP/USD: The market has now easily cleared support by the 200-Day SMA and psychological barriers by 1.6000 to open the next downside extension towards key medium-term support at 1.5700. Daily studies are however in the process of unwinding from oversold levels, and we would recommend looking to sell into rallies rather than selling on breaks. Look for any rallies to now be well capped ahead of 1.6300, where a lower top is sought out ahead of the retest on 1.5700.

USD/CHF: The break back above 1.0340 in recent weeks has been a critical development which now greatly increases the likelihood of a material shift in the structure in favor of additional medium-term USD gains. The market has also now broken back above the 100-Day SMA for the first time since May 2009, while the daily RSI has recently reached its highest levels in over a year, which further strengthens our core bullish outlook. From here, look for any setbacks to now be very well supported ahead of 1.0200, with the market now seen eyeing a test of next resistance by 1.0700 over the coming days.

FLOWS

Local accounts on the offer in Usd/Cad. French bank and US prime name demand for Eur/Gbp. Central bank and semi-official bids in Eur/Usd.

TRADE OF THE DAY

Eur/Aud: The market has been very well supported over the past decade on dips into the 1.5500 area, and given the pace of the latest declines, we like the idea of once again looking to buy into the current dip below 1.6000. Daily and weekly studies are looking quite stretched with the daily RSI already dipping below 30, and any additional declines on Wednesday into the mid-1.5600’s are sure to result in some very exhausted and overextended hourly studies. This should set up a highly compelling short-term entry for what could ultimately develop into a formidable longer-term trade. STRATEGY: BUY @1.5650 FOR AN OPEN OBJECTIVE; STOP 1.5450. RECOMMENDATION TO BE REMOVED IF NOT TRIGGERED BY NY CLOSE (5PM ET) ON WEDNESDAY. 3X LEVERAGED.

PORTFOLIO OVERVIEW

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The British Pound fell to the lowest level in a week against the US Dollar after UK consumer confidence posted the largest decline in over a year in December as stimulus measures fade and the government reverses a value-added tax reduction.

Key Overnight Developments

• UK Consumer Confidence Fell Most in Over a Year, Shop Prices Surged
• Australian Building Approvals Topped Expectations on Public Spending

Critical Levels



The Euro consolidated NY-session losses in overnight trading, oscillating in a choppy range above 1.4340. The British Pound dropped to the weakest level in a week, testing as low as 1.5945 against the greenback on a drop in consumer confidence (see below). We remain short EURUSD at 1.4881 and short GBPUSD at 1.6648.

Asia Session Highlights



UK Consumer Confidence fell more than expected in December with an index from the Nationwide Building Society slipping to 69 from a revised reading at 74 in the previous month, the largest decline in over a year. Economists were forecasting a print at 72 ahead of the release. A sub-index tracking consumers’ expectations about the economy 6 months into the future dropped to the lowest level since August 2009. Nationwide Chief Economist Martin Gahbauer said the outlook for consumer spending may turn out to be “sluggish” in 2010 as stimulus measures are withdrawn while the government returns the value-added tax (VAT) to 17.5% from 15% where it had been for past year to help deal with the burgeoning fiscal deficit.

The VAT was also a key factor behind a jump in retail inflation as the British Retail Consortium’s Shop Price Index gained 2.2% in the year to December. Indeed, the VAT was first lowered in December 2008, exactly one year before the period covered in today’s release. BRC Director General Stephen Robertson also identified “increases in the costs of oil, food commodities such as wheat and sugar and the continued weakness of the Pound” as contributing factors to higher prices.

In Australia, Building Approvals outperformed expectations to rise 5.9% from the previous month and 33.3% from a year before in November. However, the outcome is not as encouraging as the headline figure would suggest considering most of the upswing was accounted for by a huge 28.8% increase in approvals for government-funded buildings, an increase more than six times larger than the rise in permits for private construction projects. The data likely reflects a boost from the infrastructure projects approved as part of last year’s fiscal stimulus plans, meaning it says relatively little about the likelihood of a robust self-sustaining recovery in the property market even as mortgage rates begin to reflect higher benchmark borrowing costs while the government reduces its grant for first-time home buyers to A$7,000 from A$21,000.


Euro Session: What to Expect



The final revision of the composite Euro Zone Purchasing Manager Index is expected to confirm that the metric rose to 54.2 in December from 53.7 in the previous month, revealing that the currency bloc’s manufacturing and services sectors expanded at the fastest pace since October 2007. The metric has steadily pushed higher since bottoming in February of last year, upward momentum may be slowing as firms look ahead to the withdrawal of stimulus measures amid uncertainty about the pace of a self-sustaining recovery as record-high unemployment and shrinking private-sector lending continue to weigh on spending and investment. Indeed, December’s outcome will mark the smallest increase in the PMI gauge in 10 months.

Elsewhere on the calendar, Euro Zone Industrial New Orders are set to decline 1% in October, the first drop since March, likely reflecting fading support from close to $2 trillion in global fiscal stimulus that has underpinned both domestic and foreign demand over recent months. The Producer Price Index is expected to have declined -4.5% in the year to November, the smallest decline in 9 months, as rebounding commodity prices put upward pressure on wholesale inflation. However, the outcome is unlikely to prove particularly market-moving with the underlying themes behind the headline figure likely to have been priced in after yesterday’s preliminary CPI release.