Big Gains in Dollar and Oil but Beware of China

For the first time in 10 trading days the U.S. dollar ended the day higher against the Japanese Yen thanks to better than expected retail sales and a rebound in oil prices.  
Consumer spending rose 0.2% in the month of January which was only slightly better than expected but in December, retail sales was revised up to 0.2% from -0.1%.  Stronger gains were also seen in spending ex autos and gas. Consumer confidence on the other hand declined in February according to the University of Michigan. This deterioration in sentiment should not be surprising given the volatility in the financial markets.
 
In the week ahead, the market's focus will expand beyond the U.S. dollar with important economic reports and event risks scheduled for release in many parts of the world.  For the U.S., the main focus will be the FOMC minutes and unfortunately we don't expect the report to help dollar bulls. If you recall, the Federal Reserve made a number of changes to the last monetary policy statement and each adjustment pointed to a less hawkish central bank that could very well leave interest rates unchanged in March if oil prices and global equities fail to recover. They described growth as slowing late last year, pointed to weakness in inflation and warned that they are closely monitoring global economic and financial market developments.  The market is bearish dollars and dovish FOMC minutes would give investors another excuse to sell the currency.  In terms of actual data, there are a number of housing market and manufacturing reports scheduled for release along with consumer prices but none of these pieces of data are expected to have a significant impact on the dollar.  Three Fed Presidents are also scheduled to speak but only Bullard is a voting member of the FOMC this year.
 
Speaking of speeches, ECB President Draghi's appearance and testimony before the EU Parliament's economic committee on Tuesday will be the one to watch.  With European stocks falling sharply this week and peripheral bond yields surging, many investors will be eager to see if the ECB head will send a stronger signal about increasing monetary stimulus next month and we think he will.  According to the latest reports, the Eurozone economy continued to grow by 0.3% in the fourth quarter but on an annualized basis growth slowed to 1.5% from 1.6%. The big story however was Greece who fell back into recession with a contraction of -0.6% in the last quarter of the year after a drop of -1.4% in Q3. French growth slowed to 0.2% while Italian growth slowed to 0.1%.  There are no shortages of reasons for the ECB to increase stimulus and we believe that the central bank will make this clear on Tuesday.  However the euro has completely ignored fundamentals this month and traded purely on short covering flows. We are doubtful of how long this can last.
 
Chinese markets re-open after a week-long holiday and given the extensive losses in markets around the world, we are weary of a sharply lower open.  However with Chinese trade numbers also scheduled for release at the start of the week, the government could help shore up confidence by tweaking the data to show less weakness or more strength.  How China trades on Sunday night could set the tone for how global markets trade at the start of the week and the risk is to the downside. 
 
The Japanese Yen will remain in focus with investors continuing to watch for central bank intervention.  The heightened sensitivity to Japanese developments also makes this Sunday's Q4 GDP report exceptionally important.  Negative growth is expected for the second time in 2015 but since the economy rebounded in Q3, there's no technical recession.  Nonetheless the 4% drop in the Nikkei overnight and the surge in the Yen will only make life more difficult for Japanese businesses and consumers. So far, no Japanese government official has confirmed intervention but they continue to express frustration with market sentiment and volatility.
 
With no major U.K. economic reports released this past week, sterling took a back seat versus other major currencies and traded primarily on EUR/GBP flows. That should change however in the coming week with a very busy U.K. calendar that includes an inflation and labor market report.  The recent increase in U.K. yields vs. Treasury yields help to keep GBP/USD bid but continued concerns about Brexit could limit gains in the currency - according to a Reuters poll, economists see 40% chance of Brexit which certainly doesn't bode well at a time of renewed calls for Grexit. Farmers in Greece staged a massive riot on Friday about the government's pension reform plans.
 
The main reason why markets were calmer on Friday is oil.  After falling for 6 straight trading days, oil moved sharply higher on Friday after the UAE said on Thursday afternoon that OPEC is ready to cooperate on an output cut.  The rise in oil was the strongest in 7 years - we haven't heard anything yet from Saudi Arabia but their lack of denial which usually comes quickly after a misquote leads investors to believe that they are also growing uncomfortable with the commodity price level. While all of the concerns relating to supply and demand are still there, USD/CAD is steady and the sharp rebound in oil should lead to stronger recovery that could take USD/CAD down to 1.38.
 
Finally, the New Zealand dollar was hit hard overnight despite an uptick in food prices. There was no specific news to drive the decline.  The Australian dollar on the other hand held up comparatively well amidst mixed comments from RBA Governor Glenn Stevens. While he said global markets are "dropping their bundle," they can't say yet if financial turmoil will impact demand and that the Chinese economy is weaker than China would like, he continued to point to stronger demand for labor, improvements in economic activity outside of resources and the positive impact of easy monetary policy and a lower currency as cause for optimism. AUD is in play next week with RBA minutes and Australian employment report scheduled for release.