Volatility Returns to the Currency Markets

** PERCENTAGES MAY NOT ADD UP TO 100% BECAUSE OF THE PROBABILITY OF LARGER OR SMALLER MOVES BEYOND THOSE SHOWN ON THIS TABLE

VOLATILITY RETURNS TO THE CURRENCY MARKETS

The resonance of the New Year is starting to show its true colors at the start of the first full trading-week this year. The Dow finished a volatile day lower, in some ways ruining the sense of stability that pervaded in last week's market. Volatility in equity prices was complemented by some extreme moves in the fx markets. Looking at today's biggest percentage movers we can see the sheer magnitude of price action today, with some moves extending to more than 3.0%. The dollar in particular was heavily mixed across the board. We have seen some substantial gains against the euro and yen, in conjunction with weakness against the pound and commodity currencies. Today's trading was a truly unorganized and unpredictable force.

A Bipartisan Effort for Economic Relief

Originally, a moniker that can be associated with 2008, among others, is the year of the fiscal stimulus plans. However, it does not appear to be an isolated occurrence. In fact, talks from the Euro-zone, UK, and US present a new high of speculation. As of this point, the potential for an Obama Stimulus plan has been a majoring lifting factor for the dollar and risk appetite. Today, even though equity declines are unfazed, we learned of some of the more telling details behind the $775B package. As the Obama administration is planning, $300B which will be set aside for various tax-cuts for business and low to middle class workers. The main goal here is to have an immediate and lasting impact on the economy. The inclusion of a massive tax break seems a necessary component of the plan to ensure bipartisan support. However, inevitably, there are elements that Republicans are in disagreement. It is important to note that the tax-break does not include cuts in capital gains or the corporate marginal tax rate. Furthermore, Republicans are eagerly awaiting the income level at which these benefits will be capped.

The components of President-elect Barack Obama's tax plan can be divided into two parts. The first and largest initiative will be an overall reduction in payroll taxes for low to middle income workers. The second half of the plan will be reserved for struggling business. Among other factors, the main focus is to provide business with tax-related incentives that will produce increased business investment, a larger effort to hire new workers, as well as a postponement of planned layoffs. Businesses will also be allowed the privilege to write-off large amounts of 2008 related losses.

Some Unexpected Results

Today can be summed up as economic data that is undeniably terrible, but consistently better than market forecasts. Among today's example is Construction Spending that was not nearly bad as expected, declining 0.6% versus a consensus of -1.4%. It was shown that spending on commercial and government construction was enough to partially offset the usual declines in the residential housing market. However, it is important to note that the figure was still weaker on a month-over-month basis. The other similar story of the day was that General Motors showed December sales were actually up from a month earlier, apparently as the result from its government loans. However, overall yearly sales have reached a level not seen since the middle of the twentieth century. Sales for Chrysler on the other hand were down more than 50% for December alone.

Only time shall tell if these economic surprises continue. The first test for this revised sense of optimism is in tomorrow's Pending Home Sales, Non-Manufacturing ISM, and the FOMC Meeting Minutes. Of the most relevant information will be the minutes. However, we can no longer sort through it hoping for some intentional hints for continued rate cuts. That possibility is currently off the table. The more predictive value will come from possibilities regarding Quantitative Easing policies that the Fed is expected to pursue in their continued monetary measures.

EUR/USD: STIMULUS PLAN SPECULATION ERUPTS IN EUROPE

In the intensified round of new fiscal stimulus speculation, Germany is yet another trying desperately to induce political cooperation. There have been talks of a new €50B German package, its second attempt during the financial crisis, which will involve mostly infrastructure investment and reduced Social Security contributions. However, the intensifying political deliberations will most likely stall the plan, and inherently limit its effectiveness. Among primary quarrels, the issue of taxation has taken center stage. As a temporary agreement, the German government has modestly increased the tax free allowance. In another round of sensitive economic information, we learned that Sentix Investor Confidence is off at least a temporary low. The measure increases for the first time in seven months, rising from -42.3 to -34.4. Even though sentiment is still dwindling, as per the recession warrants, it is a reassuring figure that shows some immediate satisfaction from the ECB's 75bp rate cut last month. Other figures are not as promising.  Italy, the Euro-zone's third largest economy, is facing a deflationary assault with prices dropping to fourteen month lows. It is likely that this development will resonate to other EZ countries, forcing the ECB to respond with rate cuts of equal or more aggressive pressure. As a further gage of ECB actions, Germany's PMI Services and EZ CPI Estimate will be released tomorrow. If Italy's inflation serves as a predicting force, it is expected that ECB measures will be confined to a dovish stance in limiting the potential for deflation.

GBP/USD: BoE CONTINUES ATTEMPTS TO REIGNITE LENDING

The BoE's rate decision is quickly approaching, and will be officially released on January 8th. It is no longer the large rate cuts or dovish rhetoric that will make news, rather the potential for Fed-like measures. Expectations are calling for an array of possibilities, all of which aimed at making financial institutions more willing to take the risk of lending once again. A much speculated measure may call for an enlarged Special Liquidity Scheme, which would allow banks to temporarily swap their high-quality asset-backed securities in return for UK Treasury Bills. This liquidity injecting plan will be able to relieve some strains off of the balance sheets of the banking industry. Hopefully, as the BoE is expected to cut an additional 50bp, they will be able to transfer their historically low target rate to the borrowers who are unable to finance their activities. As a result, the pound is a broad winner against even the euro, of which is finally coming off a record-setting string of successive record highs. An enhanced sense of the overwhelming obligation for the BoE to continue cutting rates is that PMI Construction fell by the fastest rate in about ten-years. Tomorrow, the UK is scheduled to announce PMI Services, Nationwide House Prices, and Official Reserves. It is unlikely that the momentum behind a rate cut Thursday will be altered by any unexpected strength in these indicators.

USD/CAD: CRUDE OIL PUSHES FOR SUBSTANTIAL CAD RALLIES

The Canadian dollar makes some impressive advances against the dollar and yen. The rally in crude oil is particularly boosting the pair, as it approaches a three week high. Oil is pushing higher on heightening Middle-eastern conflicts along with the potential for additional OPEC production cuts, such geopolitical factors may spell the end for historically cheap gas prices. USD/CAD is down more than 150 pips and CAD/JPY is up more than 200 pips. Gold on the other hand is losing strength, off more than 3.0% on the day. The oil story is still enough to improve risk appetite to foster impressive commodity currency rallies. The aussie and kiwi are also up on the day. However, fundamental data is sparse for all commodity currencies. The only relevant data ready to be released is tomorrow's New Zealand Trade Balance. Aside from this, any market moving information will rely completely on altering investor confidence and sentiment.

USD/JPY: THE YEN WEAKENS ONCE AGAIN ON IMPROVED RISK APPETITE

USD/JPY is off to another strong rally, even as US equities are struggling. The return of some levels of risk tolerance seems most apparent in the strong rallies imposed by yen crosses. Once again, in the face of a sheer lack of Japanese data, the yen is weakening substantially, to the delight of the Bank of Japan. This may be one of the reasons why the bank has been quiet as of late. The anticipated measures of quantitative easing have been temporarily postponed as a result. However, the factors affecting the economy will not be offset by a few weeks of yen weakness. As another boost to morale, the Nikkei index is reaching its highest levels since mid-November. The US indices are apparently not the only ones to respond favorably to the onset of a new year, as most Asian indices are currently on a winning streak. Aside from the Monetary Base being released this evening, there will be no significant data on the schedule for tomorrow.

GBP/USD: Currency in Play for Next 24 Hours

GBP/USD will be the currency in play over the next 24 hours on some key UK data that is poised to influence the sizeable rate cut expected on Thursday. First, the UK will be reporting Nationwide House Prices at 2:00 am ET or 7:00 GMT. Scheduled for later in the day are PMI services and Official Reserves, both expected at 4:30 am ET or 9:30 GMT. On the US side, we will see Pending Home Sales and on-Manufacturing ISM at 10:00 am ET or 15:00 GMT, and the FOMC Meeting Minutes at 2:00 pm ET or 19:00 GMT.

Trading in GBP/USD continues to isolate itself within a significant consolidation range, resulting in a Bollinger band range trading zone. A significant catalyst will be needed to remove the pair from the confines of this pattern. The most immediate support is low at 1.4350. However, more significantly is the 1.4000 level, both a low extending back to 2001 and a psychological level. To the upside, the pair faces 1.5535 which coincides fairly accurately with two previous highs and a low from October. Once again, this consolidation phase that has been tested for the last two months is unlikely to face any pressure until the BoE decision coming up later this week. A break of 1.4000 could result in another continuous downward spiral.

Kathy Lien
http://www.gftforex.com

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