Risk aversion continues to seep through the markets, driving investors into the safety of the 2 lowest yielding currencies, the US dollar and the Japanese Yen. The demand for dollars and yen has nothing to do with the outlook for the US and Japanese economy, both of which are very bleak. Instead, when investors are nervous they tend to reduce their positions which are frequently funded by cheaply borrowed dollars and yen. After liquidating, investors park their money in the safety of US Treasuries and by extension the US dollar. In this current market environment, the strength of the US dollar is not a reflection of the strength of the US economy or even the hopes of a faster recovery.

Beige Book Blues

It is no secret that the US economy is in serious trouble. In fact you cannot walk into a restaurant or a bar without hearing someone talk about the problems in the economy. The latest Beige Book report shows that the pain is not over. According to 12 Fed Districts across the nation, the economy weakened throughout December and into the first days of 2009. There was nothing positive in the report as weaker activity was seen in the manufacturing sector, housing and labor market. It may be some time before we see any pickup in the US economy because now that the holiday shopping season is over, consumers may cut back even further. The Federal Reserve looks at the Beige Book report to help determine their monetary policy decisions and based upon the dismal outlook, the central bank will probably keep interest rates low for an extended period of time.

The Grinch Stole Christmas

For the 6th month in a row, US consumers have cut back spending. The December consumer spending data tells us that retailers had a very tough time this holiday shopping season. Consumers reduced their spending by 2.7 percent but if you take out year end deals in the auto sector, retail sales actually fell 3.1 percent, the largest decline in at least 16 years. The Grinch really stole Christmas this year and no one is happy about it. Lower gasoline prices continued to drive down gas station receipts, but weaker spending was seen across the board. The worry now is that more retailers will be forced to file for bankruptcy protection and the latest consumer spending reinforces those fears. With more than 1 million Americans out of work in the last 2 months, concern about job security has led to more nimble shopping over the Christmas holidays. Import prices dropped for the fifth month in a row, but by less than the market had expected.

Watch Out for a Sharp Contraction in Q4 GDP

Expect fourth quarter GDP to be very weak. Retail sales are one of the primary inputs to GDP and the sharp drop in consumer spending suggests that GDP could have fallen by more 4 percent. JPMorgan actually expects GDP to drop by 5.5 percent while Deutsche Bank is calling for a 6.5 percent decline. Either way this would be the largest contraction in growth since 1982 when GDP shrank 6.4 percent in the first quarter. Interest rates back then were much higher than where interest rates are now so the Federal Reserve's natural response was to ease aggressively. With no room to cut interest rates to support the economy, the current recession could be dragged out longer. Producer prices, jobless claims, the Empire State and Philadelphia Fed manufacturing indices are due for release tomorrow. The market expects producer prices to fall at a slower pace which is confirmed by the smaller decline in import prices. The manufacturing sector should remain weak, but a modest rebound is expected as well.

The big story today in the financial markets today is in the Eurozone. Not only is the Euro continuing to weaken against the US dollar on the expectation that the European Central Bank will cut interest rates by 50bp on Thursday, but it has also been hit by Standard and Poor's downgrade of Greece's sovereign debt rating to A- and rumors that Ireland may seek help from the IMF. The downgrade of Greece follows official warnings about potential downgrades for Spain, Ireland and Portugal. Falling tax receipts has made the ratings agency extremely concerned about the budgets of these nations. A downgrade increases the cost of borrowing for Greece which puts the country at greater risk. As for Ireland, they have denied that they will seeking IMF funding, but the rumors reflect the market's concern about the economy.

ECB Preview: Will Trichet's Comments Save the Euro?

Of all the major central banks in the world, the ECB has been one of the least aggressive. Since the beginning of 2008, they have cut interest rates by only 150bp, an insignificant amount when compared to the actions taken by the BoE and the Fed. The ECB has been close lipped about how much they plan to cut interest rates, but the market is pushing for a 50bp rate cut that would take Eurozone interest rates down to 2 percent. However given the track record of the ECB, there is no doubt that central bank President Trichet would postpone additional rate cuts if it were in any way possible. In comments made today, while acknowledging the severe economic downturn, he seems optimistic in a full recovery by 2010. The central bank head has also repeatedly supported the fact that his string of rate cuts has not yet been acknowledged by the financial markets. It is a monetary reality that interest rate decisions made by central banks have a lagging impact on an economy, often taking more than six months to reveal possible effect. However, the fact of the matter is that the lack of action will leave the Euro-zone very vulnerable in the event that the situation worsens. Therefore we wouldn't completely rule out a 25bp rate cut or a half point cut accompanied with not so dovish comments.

The economic condition of the Euro-zone has only managed to worsen since last month's meeting. EZ PPI fell by the most in three-decades, Industrial Production dropped by the most in eighteen years while German unemployment rose for the first time in nearly three years. This serves as a severe shock to business and consumer confidence which Trichet personally promotes as a vital ingredient for his optimistic turnaround by 2010. With nearly all EZ countries struggling within the clutches of recession, the ECB will have to act fast to prevent another round of financial destruction.

The British pound was one of the few currencies that managed to strengthen against the US dollar. There was no economic data released from the UK while Barclays PLC, the country's fourth largest bank announced plans to cut 2000 jobs. The strength of the British pound suggests that investors are finally reacting to the stimulus announced by the UK government. They have tried everything from cutting interest rates, cutting taxes, taking stakes in banks, offering cash for the unemployed to start businesses and now a loan guarantee program aimed at small and medium size companies. The UK government is committed to turning around the economy and their ground breaking efforts confirm that they are doing everything in their power. Even if the British pound's rally turns out to be short-lived, we are still optimistic that the UK will be one of the first countries to recover from the global recession.

The Australian and New Zealand dollars are down 6 percent year to date as investors grow more concerned about the outlook for the commodity producing countries. New Zealand has been put on credit watch by Standard and Poor's. The country is in a recession, while its debt and current account deficit are rising. The slowdown in China and the drop in commodity prices are also not helping. Gold and oil prices continued to fall, driving the Australian, New Zealand and Canadian dollars lower. Australian employment numbers are due for release this evening. Job advertisements fell significantly but the employment component of service, manufacturing and construction sector PMI improved which means that the labor market deteriorated but perhaps not by as much as the market expects.

Japanese Yen crosses continued to fall as the Dow Jones Industrial breaks its December lows. USD/JPY is moving in lockstep with US equities and that correlation is not expected to change any time soon. Machine tool orders was the only piece of economic data from Japan and according to the report, orders slipped 71 percent. Tonight we are expecting a few more pieces of Japanese economic data including machine orders and domestic CGPI.
USD/JPY: Currency in Play for Next 24 Hours

The currency in play over the next 24 hours is the USD/JPY. Japanese machine orders and the CGPI index are due for release at 23:50 GMT or 6:50pm EST while US producer prices are due for release at 13:30 GMT or 8:30 EST.

USD/JPY is trading well within the Sell Zone, which we determine using Bollinger Bands. Moving averages are in perfect order which means that the shorter term moving averages are below the longer term moving averages. This suggests that the downtrend in USD/JPY is strong. As long as the currency pair does not close above 89.50, we could see a move down to support at 87.15, the December lows. If it breaks today's high of 89.97, the downtrend is negated and we could see a move towards the second standard deviation Bollinger band at 92.