Recovery in USD/JPY Hinges on Fed Minutes, Payrolls

• Recovery in USD/JPY Hinges on FOMC and NFP
• EUR: Holds 1.36 on Outlook for Germany
• GBP: Temporary December Slowdown?
• AUD: Positioning Overshadows Data
• NZD: Shrugs Off Slower Australian and Chinese Services Data
• CAD: IVEY and Trade Data Due Tuesday                                                                  
• USD/JPY - Struggles to Regain Upside Momentum

Recovery in USD/JPY Hinges on Fed Minutes and NFP

The U.S. dollar traded lower against most of the major currencies today in what has been a slow start to a busy week.  There is potential for big moves in the forex market this week but volatility may not pick up until Wednesday because the trade balance is the only piece of U.S. data on the calendar tomorrow. This means that the greenback could take its cue from U.S. yields. If 10 year Treasury yields continue to fall, the dollar could slip lower. The December FOMC minutes and non-farm payrolls report are the most important U.S. events on the calendar.  While the focus is generally on NFPs, but we believe that the minutes could have a larger impact on the dollar than payrolls because the Federal Reserve laid out their plan to taper asset purchases and wind down Quantitative Easing at their last meeting. Investors are now eager to learn their motivation and level of enthusiasm for tapering.

We know that every FOMC voter with the exception of Rosengren favored the move and Bernanke believes that bond purchases will be reduced by $10 billion at every meeting until the entire program is drawn to a close but remember, this is his suggestion and not an official decision. From February 1st onwards, Bernanke will not be involved in any monetary policy decisions.  If the FOMC minutes show that there was an overwhelming amount of support for tapering before the end of the 2013 their enthusiasm will revive the rally in the dollar and drive USD/JPY back above 105.  However if there was significant reluctance and policymakers expressed hesitancy about staying on a predetermined track with bond purchases, then the dollar could come under additional pressure.  Boston Fed President Rosengren did not support the move last month because he felt that unemployment is too high and inflation too low. With 1.3 million Americans losing their unemployment insurance at the start of the year, the labor market is still a legitimate headache for the central bank and there are many valid reasons for why some policymakers would prefer to make future tapers data dependent.  At the same time, there are Fed Presidents such as Lacker who believe that it would take significantly weaker economic activity to slow tapering. However neither Rosengren nor Lacker are voting members of the FOMC this year.  Plosser who is a voter said on Friday that the Fed might have to raise rates aggressively to regain some lost ground after Bernanke brought rates to zero. If the rest of his peers share his view, the dollar could start the New Year off strongly. The bottom line is that the central bank's eagerness to wind down QE and their rationale for tapering in December will largely determine how well the dollar trades this week.

Friday's non-farm payrolls report will also play a big role in shaping expectations for the pace of Fed tapering this year.  According to this morning's non-manufacturing ISM report, service sector activity slowed in the month of December but the labor market continued to grow.  The non-manufacturing ISM index dropped to 53 from 53.9 but the employment component of the report jumped to 55.8 from 52.5. As a service based economy, this underlying component has a very strong correlation with non-farm payrolls and suggests that Friday's report could surprise to the upside. A good number would create renewed demand for dollars and a much needed recovery for USD/JPY.

EUR: Holds 1.36 on Outlook for Germany

The euro rebounded against the U.S. dollar ahead of important German data. Even though Germany's PMI services index was revised slightly lower for the month of December, the Eurozone's largest economy is expected to drive growth for the region in 2014. Manufacturing is the engine of growth for the overall economy and it remains strong with the PMI index rising to its highest level in 2.5 years.  New orders have also been on the rise reflecting an increased in external demand and this helped boost business and consumer confidence.  Tomorrow's German retail sales and unemployment reports should provide further evidence of the country's recovery and give the European Central Bank the confidence to indulge the market in some optimism.  Economic activity is expected to improve in the Eurozone this year albeit gradually especially compared other countries around the world. France is going to be a big problem in 2014 so even if the ECB sees a brighter outlook for the region, they will be reluctant to let up on their easing bias or their warnings about an uneven recovery in the region.  With the Fed poised to end QE this year, we see the EUR/USD lower especially if this week's FOMC minutes show a strong commitment to tapering and non-farm payrolls surprise to the upside.  Yet we can't lose sight of the fact that EUR/USD will be supported by its record current account surplus so U.S. data needs to be very good in order to do some real damage to EUR/USD.  Otherwise we expect brief rallies like the one seen today in an overall choppy environment with a lower general bias.

GBP: Temporary December Slowdown?

The British pound ended the day unchanged against the U.S. dollar as investors wonder if slowdown at the end of last year will be temporary. The U.K. economy experienced a weak end to a strong year with manufacturing, service and construction sector activity declining in the month of December.  While all 3 sectors continued to expand, the pace growth slowed. The PMI services index was released this morning and it dropped to a 6 month low of 58.8 from 60.0.  However with the employment and expectations component of the report rising, this may be nothing more than a decline off of lofty levels.  The same was true for the manufacturing PMI index which saw an increase in employment and new order growth even though the overall index declined. Construction sector activity expanded at its fastest pace in 6 years prior to last month's small decline.  The bottom line is that there is nothing particularly concerning about the recent pullback in PMIs.  If the downtrend continues for the next 2 months we will be worried but between now and then, we are still looking for a stronger recovery in the U.K. this year.

AUD: Positioning Overshadows Data

The Australian and New Zealand dollars traded higher against the greenback despite weaker than expected economic data.  Service sector activity in Australia contracted at its fastest pace in 4 months with the PMI index dropping to 46.1 from 48.9.  Both the employment and new orders component of the report fell steeply, a sign that domestic demand is weakening quickly.  Economic activity in Australia has been hampered by slower growth in China.  Last week we saw evidence of slower manufacturing activity and overnight, the HSBC services PMI index for China dropped to 50.9 from 52.5 in November.  The Chinese economy peaked near the end of last year and with growth expected to weaken further in 2014, Australia is poised for a tough year.  However the Australian dollar has taken the news in stride for 2 reasons - positioning and gold.  The latest CFTC IMM report shows that speculators remain very short AUD, which means that in order for traders to add to their existing short positions, data needs to be very weak.  It also means that the currency pair is vulnerable to a short squeeze as it won't take much for speculators to want to bank profits.  That's where gold comes into play - the yellow metal started the year strong with its gains lending support to A$.  90 cents is the level to watch for AUD/USD.  If the currency pair breaks above this resistance, it could squeeze as high as 0.9150 but fundamentally, we will look at the rally as an opportunity to sell at a higher level. Australia's trade balance is scheduled for release tomorrow but the focus will be on Canada.  Mixed inflation numbers drove the Canadian dollar higher against the greenback but these reports are not as important as Tuesday's IVEY PMI index and trade numbers.  While Canada is expected to report a small trade deficit for November, manufacturing activity is expected to have improved in December, which could lend support to the currency and keep USD/CAD within a 1.0740-1.0550 range.

USD/JPY - Struggles to Regain Upside Momentum

With the Nikkei falling more than 2% overnight and U.S. 10-year Treasury yields dropping below 3%, USD/JPY struggled to recapture 105.  Although the currency bounced off its 103.91 low intraday, the lack of support from equities or Treasuries makes it very difficult for the currency pair to rally.  The weakness of USD/JPY also put pressure on the other Yen pairs.  However from a technical and fundamental perspective, we believe that it is only a matter of time before USD/JPY rises once again.  On both Friday and Monday, the currency pair ended the day well off its lows, creating a long wick on the candlestick chart that is generally indicative of a reversal.  Fundamentally, we expect this week's FOMC minutes and non-farm payrolls report to be positive for the dollar.  The Nikkei should also recover because Japan's economy is gaining momentum.  Service activity increased in December with Japan's PMI index rising to 52.1 from 51.8.  Solid domestic demand boosted new business and made companies in the service sector more optimistic about future economic activity.  With the consumption tax expected to increase in April, consumer demand in Japan should be particularly strong in the first quarter as the Japanese rush to buy before taxes increase.  No major Japanese economic reports are scheduled for release this evening, which means all eyes will be on Japanese stocks.