Daily FX Market Roundup 01-03-13

By Kathy Lien, Managing Director of FX Strategy for BK Asset Management

USD Soars - Is the Fed Serious about Ending Bond Purchases?
EUR: Breaks 1.31, Shrugs Off Labor Market Improvement
GBP: Dragged Down by Weaker Housing Reports
AUD: Service Sector Experiences Deeper Contraction in December
CAD: Zero Job Growth Expected in December
NZD: Comm Dollars Supported by Stronger Chinese Data
EUR/JPY Leads Decline in Yen Crosses

USD Soars - Is the Fed Serious about Ending Bond Purchases?

It was a relatively quiet day in the foreign exchange market up until the Federal Reserve released the minutes from its last monetary policy meeting. The U.S. dollar shot higher against all of the major currencies after the FOMC minutes revealed a debate over when to end asset purchases. Up until the release of these minutes, the central bank went through great pains to let the market know that they plan to keep monetary policy easy and interest rates at ultra low levels for an extended period of time. At their last meeting, they even shifted to an unemployment rate target, which the market perceived to be extremely dovish. However according to the FOMC minutes, the Federal Reserve may not be as dovish as they had led everyone to believe. Some members of the monetary policy committee want to end asset purchases by the middle of this year, others want it to continue until year end while argued for the program to continue beyond 2013. The fact that members of the Fed are talking about ending asset purchases at all was a big surprise but the talk of doing so in the next 6 to 12 months led many traders to reconsider their short dollar positions.

Having just adopted an unemployment rate target, other investors are wondering if the Federal Reserve is serious about ending bond purchases. The jobless rate has fallen significantly over the past year but is it too soon to withdraw stimulus particularly since the last Fed meeting was held before the Fiscal Cliff deal? We think the answer is yes and many Fed officials probably would agree but unfortunately their motivation for ending asset purchases has less to do with their optimism about the U.S. economy and more to do with their concern about the effectiveness of additional asset purchases and the costs that it would have on the financial markets. The Fed is still committed to keeping interest rates near zero until the unemployment rate hits 6.5% but if labor market conditions continue to improve, they may opt to curtail other programs. If they choose to do so, regardless of the motivation, the U.S. economy will be left with less stimulus and that is positive for the U.S. dollar. The main takeaway is that the Fed is trying to separate QE from ZIRP but they won't take any new steps until the second quarter at the earliest. Nonetheless the game is shifting and we'll have to listen carefully to each and every word that U.S. central bankers start to say and not say from here on forward.

In the meantime, the sustainability of the dollar's gains could hinge on Friday's non-farm payrolls report. Strong job growth will support an earlier end to bond purchases while weak job growth will make investors skeptical of the Fed's hawkishness. Based on the decline in jobless claims last month, the drop in layoffs and strong rise in private sector payroll according to ADP, non-farm payrolls growth is expected to have accelerated December. However the gain over the previous month should be small considering that consumers grew less optimistic. Investors will now look to the NFP report for validation on the Fed's less dovish monetary policy bias.

EUR: Breaks 1.31, Shrugs Off Labor Market Improvement

While the euro dropped more than 1% against the U.S. dollar on the heels of the FOMC minutes, the currency pair had been weak going into the North American trading session. Better than expected employment numbers out of Germany failed to lend support to the currency. The improvement was small with only 3K workers losing their jobs in the month of December compared to 5K in November. The unemployment rate held steady at 6.9%. The divergence between the performance of the EUR/USD and U.S. stocks has continued as stocks held steady while the EUR/USD extended its losses. The weakness of the EUR/USD reflects the skepticism of currency traders who were not convinced that the Fiscal Cliff deal was enough to remove the risks in the financial markets. Considering that negotiations still need to happen around the debt ceiling and spending cuts, their concern is probably warranted. Nonetheless, given the breakdown in the correlation between the EUR/USD and stocks, either stocks are due for a correction or the sell-off in the EUR/USD is overdone and unfortunately we believe it's the former and not the latter that will need to correct. German retail sales are scheduled for release on Friday along with final Eurozone and German PMI services. Today's German labor market numbers were better than expected but consumer confidence has declined and most importantly, retail sales hit its lowest level in 8 months according to Markit's Retail PMI report. Therefore unfavorable weather, competition and lower foot traffic could lead to a downside surprise in retail sales.

GBP: Dragged Down by Weaker Housing Reports

Weaker thane expected economic data and broad dollar strength drove the British pound lower against the U.S. dollar. For the third time in 4 months, the GBP/USD failed at 1.63, a level that is proving to be increasingly difficult for the currency pair to breach. With today's sell-off, GBP/USD is poised for a move down to support at 1.60. House prices declined 0.1% in the month of December according Nationwide Building Society, a leading mortgage lender in the U.K. The softness of the housing market should not surprise any of our readers considering that we have been writing about the failure of the government's Funding for Lending Scheme for some time nnow. The program may be ambitious but so far there has been little uptake. As a result, construction sector activity also contracted at a faster pace last month. PMI services are due for release tomorrow along with net consumer credit and mortgage approvals. Once again, we expect very little momentum in the housing market but service activity could tick higher like the manufacturing sector, which expanded for the first time in 8 months.

AUD: Service Sector Experiences Deeper Contraction in December

All 3 of commodity currencies were dragged lower by the rally in the U.S. dollar but the Australian dollar held up the best against the greenback thanks to stronger Chinese data. As reported by our colleague Boris Schlossberg, "Chinese services PMI surprised to the upside hitting a four month high as it rose to 56.1 versus 55.6 the month prior. This the best reading since September of last year and the tenth consecutive month that the service sector PMI remained above the 50 boom/bust line suggesting that the Chinese economy may have stabilized with economists predicting that overall GDP growth rate in Q4 of this year increased to 7.8% from 7.4% the quarter prior." As we wrote in our Top Trades for 2013, Australia's economy stands to benefit the most from upside surprise in Chinese data because it is the most heavily geared towards the Chinese economy. China is Australia's number one trade partner and its economy is therefore extremely sensitive to the ebbs and tides of the Asian giant. Stronger growth in China will help Australia's economy recover. According to the latest PMI report, service sector activity in Australia contracted at a faster pace in the month of December as the country's PMI index dropped from 47.1 to 43. Canadian employment numbers are scheduled for release on Friday. Economists are looking for zero job growth in December after exceptionally strong job growth in November.

EUR/JPY Leads Decline in Yen Crosses

While the Japanese Yen traded only slightly higher against the U.S. dollar, it soared against other major currencies. With Japanese markets closed last night, no economic data was released from Japan so therefore the decline in the Yen crosses was driven entirely by the weakness of high beta currencies. EUR/JPY fell the most followed by GBP/JPY and CHF/JPY. CAD/JPY and AUD/JPY actually rose to a fresh multi year high before being hit by the declines in the AUD and CAD. No Japanese economic data is scheduled for release this evening, leaving the Yen crosses at the whim of risk appetite.