Amid Rising Turmoil, Euro Stages a Minor Miracle

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The euro ended Tuesday unchanged against the US dollar (USD), which was impressive considering that Italian ten-year bond yields jumped 40 basis points (bps) to the highest level since November, and Italy's stock market plunged close to 5%.

The uncertainty created by the Italian election drove investors out of Italian assets, and most European instruments in general. Stock markets across Europe plunged, while Spanish bond yields spiked higher alongside Italian yields.

The risk of investing in Europe has increased, and yet, the EURUSD has still managed to hold above 1.30. This suggests that either currency traders are overly optimistic and will join the selling soon, or they are looking beyond the immediate mess to the possibility of a grand coalition between Pier Luigi Bersani and Silvio Berlusconi, which would avoid the need for another Italian election.

While a grand coalition could initially be positive for the euro, in the long run, it may still be very difficult to implement further austerity. We believe that the key lies in Italian bond yields. If borrowing costs continue to rise for the rest of the week, it may be difficult for the EURUSD to hold above 1.30. However, if yields start to decline and the market seems pleased with a potential Bersani/Berlusconi coalition, it would be a stronger argument for a recovery in the EURUSD.

Also read: Italy: The Epicenter for Market-Moving News

Eurozone consumer confidence numbers are due for release on Wednesday. The increase in business and investor confidence for Germany hints at the possibility of an upside surprise. Investors will most likely look beyond these numbers, however, because recent developments have created new uncertainty for the currency.

More: See the complete Economic Calendar

Bernanke Dovish, but Not Dovish Enough

The big focus during the North American session was Federal Reserve Chairman Ben Bernanke's semi-annual testimony on the US economy and monetary policy. Bernanke was dovish, but at the same time, he didn't dismiss the idea of tapering off asset purchases, which was enough to keep the dollar bid on a day with very strong economic data.

Bernanke started his testimony by saying that the benefits of easing outweigh the costs, but went on to add that the Fed has the tools to tighten monetary policy and that more quantitative easing (QE) may erode confidence in the Fed's ability to exit.

Concerns about unwinding asset purchases are the main motivation behind calls to phase out asset purchases, and it appears that in some ways, Bernanke shares this view. However, with the job market remaining "generally weak" and inflation well anchored, the Fed Chairman isn't in a rush to talk about exit strategies and instead confirmed that the central bank intends to sustain easing for as long as needed.

Read More: Dollar Aims Higher on Key Bernanke Testimony

Durable goods and pending home sales are due for release on Wednesday alongside day two of Fed Chairman Bernanke's testimony to Congress, this time before the House.

British Pound Holds Steady on Both Sides of the Pond

The British pound (GBP) ended Tuesday lower against the US dollar and euro but continues to hold up well considering the recent downgrade of UK credit. We still believe that the currency is poised for further losses, however, and this selloff could be just the beginning.

UK economic data continues to surprise to the downside, with home loans declining, according to the British Banker's Authority, and the CBI retail sales index has fallen to a five-month low in February.

Consumer spending has been the Achilles heel of the UK economy, and so far, it appears that there is no relief. The latest data suggests that consumer spending remained weak in February after falling in January. According to the Confederation of British Industry, grocers reported the largest decline in sales since November 2008, while clothing, furniture, and non-store retailers posted strong growth.

Still, the volume of orders placed with suppliers dropped to its lowest level since November 2011, which is terrible news for the British pound and does not bode well for GDP growth in the first quarter. Revisions to Q4 GDP are due for release on Wednesday, but we don't expect any major changes. If the UK economy proceeds at its current pace, it could be at risk for a double-dip recession.

Bank of England (BoE) markets director Paul Fisher also spoke, and he explained why he voted in favor of more easing in February. The monetary policy committee member said that "Rather than a very large, rapid programme of asset purchases to avoid an imminent slump—as was needed in 2009 and again in 2011-12—a slower, more gradually supportive policy might be more appropriate." This could be "the first installment of a more prolonged run of purchases at a somewhat slower pace than previously." These comments suggest that Fisher is not only supportive of more QE immediately, but further easing beyond the initial move.

New Zealand Trade Surplus Turns into Deficit

The New Zealand (NZD) and Australian dollar (AUD) both extended their losses against the US dollar, while the Canadian dollar (CAD) stabilized. The New Zealand dollar dropped the most, but the move was not driven by economic data.

While the country's trade balance numbers were released, the selloff in the NZDUSD occurred throughout the European and North American trading sessions. This selloff may have more to do with the NZDUSD's correlation with commodity prices. The currency pair has a particularly strong relationship with the price of copper, and the 6% decline in copper prices since the beginning of the month foreshadowed the recent pullback in the NZDUSD.

New Zealand trade numbers only added to the pain, with the country's NZD 534 million trade surplus turning into a deficit of NZD 305 million in the month of January. The combination of weaker exports and stronger imports weighed heavily on trade activity.

In contrast, it has been relatively quiet in the Australian and Canadian dollars. The AUD pushed slightly lower against the greenback, while the CAD consolidated after seven straight days of gains. No economic data is expected from any of the three commodity-producing countries on Wednesday.

Expect Bank of Japan Governor Nomination within 48 Hours

With the exception of NZDJPY, all of the other Japanese yen crosses stabilized after Monday's sharp slide. We are still in “wait and see” mode with regards to the Bank of Japan (BoJ), however. Haruhiko Kuroda is the leading contender for the Governor’s post, and according to officials in the opposition party, the Democratic Party of Japan is open to backing Kuroda for BoJ Governor.

Toshiro Muto seems to be most out of favor, and apparently, some Democratic Party officials are concerned about Kikuo Iwata's previous criticism about the central bank. If Kuroda is nominated as BoJ Governor, Iwata could still be chosen as one of the Deputy Governors.

We believe it is about time for Prime Minister Shinzo Abe to make his announcement, and we expect this to occur within the next 48 hours. When the announcement is made, we expect a knee-jerk reaction in the yen, followed by a larger move once we hear initial comments from the new BoJ Governor.

Abe's selection would still need to be confirmed by the upper and lower houses, but it appears that Kuroda would have the support of both. As mentioned yesterday, when the nomination occurs, we expect Kuroda to publicly affirm his commitment to aggressively easing monetary policy and reaching the BoJ's 2% inflation target within two years.

It is important to remember that the Bank of Japan has not changed monetary policy this year. Current BoJ Governor Masaaki Shirakawa's plan is to increase asset purchases in 2014, leaving the door open for the new BoJ Governor to make changes this year. When the new central bank head takes office in April, he is widely expected to act aggressively. On the data front, Japanese retail sales are due for release alongside the Cabinet's Monthly Economic report.

By Kathy Lien of BK Asset Management

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.
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