There’s a lot of U.S. event risk on the calendar today and the air of excitement can be felt throughout the foreign exchange market. The EUR/USD and USD/JPY are trading very well and this pushed many of the euro and yen crosses higher. The EUR/USD broke above 1.35 for the first time in 14 months and after the move occurred, the rally extended as high as 1.3560. USD/JPY also rose to its highest level in 2.5 years, which is significant but not by much considering that the new high was less than 20 pips above the previous one. Also, it is worth noting that the commodity currencies (AUD, NZD and CAD) have not participated in the rally which implies that risk appetite is limited.
Unfortunately, some of the excitement this morning was sapped by the shocking weak U.S. GDP report. We learned that the U.S. economy contracted for the first time since 2009 by 0.1%. Economists expected GDP growth to slow but not by this much. The problem was defense spending which fell a whopping 22% last quarter but while GDP was a headline shocker, the sell-off in USD/JPY was limited because the details were not nearly as bad. Disposable income hit its highest level since Q2 of 2008 while residential investment rose 11.9%, the strongest gain since 1992. Consumer spending also rose 2.2%, which was stronger than expected and up from 1.6% in Q3. As a result, we don’t expect the Federal Reserve who will make its monetary policy announcement later this afternoon to be overly concerned about the contraction in GDP growth. The chance that the contraction in Q4 will turn into a recession in 2013 is extremely low especially because spending, which is the most important component of GDP increased. The U.S. economy is still on track for a continued recovery this year. The ADP employment report also beat expectations, rising to 192k from 185k in January. ADP is not the best leading indicator for non-farm payrolls but it can be reliable directionally.
As for the FOMC meeting, no changes to monetary policy are expected this afternoon but if there are any, they will be minor. The overall tone of economic data has not changed much since the December meeting. While job growth slowed and the unemployment rate ticked slightly higher at the end of the year, retail sales rebounded, service and manufacturing sector activity expanded. Sales of new and existing homes declined between November and December but the last data the Fed had on hand in December were the October numbers and more homes were still sold in December versus October. Stocks also performed extremely well climbing to 5-year highs while 10 year bond yields tested 2% for the first time since May. The IMF believes that the U.S. recovery is on track and expects U.S. to lead growth in Westernized nations this year. However with job growth slowing and consumer confidence plunging, the Fed won’t be overly eager to remove stimulus. As a result, we expect the central bank to continue to say, “economic activity and employment have continued to expand at a moderate pace.” They could remove the line that says “strains in the global financial markets” pose downside risks but the need for continued balance sheet expansion remains in place “if the outlook for the labor market does not improve substantially.” If the Fed leaves the FOMC statement virtually unchanged, the impact on the dollar should be limited. However, if they change the statement enough to suggest that they have grown less dovish, we could see a new leg higher in USD/JPY.