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Further Euro, Aussie Losses Next Week

Today's core PCE price data have finally produced the confirmation that an inflation slowdown is underway. The month-to-month core PCE price index slowed from 0.2% to 0% in November, the lowest level in 5 years -- when rounding it to 2 decimal figures at 0.04%. The year on year level gauged by the Fed slowed to 2.2% from 2.4%, the lowest figure since May's 2.2%. The Core PCE price index shows inflationary pressures are indeed weakening, helping to confirm that the sub 0.2% readings in core CPI over the last two months were no aberration.

The annual core price index of 2.2% has now lifted the real fed funds rate to 3.05%, the highest since March 2001. With real rates at their highest in over 5 1/2 years, the Federal Reserve can now afford to worry about the deteriorating state of manufacturing and housing. Yesterday's Philly Fed survey was a case in point.

Thursday's much anticipated December Philly Fed survey fell to its worst level since April 2003. The importance of the survey lies in its close relation with the Fed's easing cycle. The chart below shows how the index slumped to -13.9 in September 1998, prompting the Fed to begin a series of 3 rate cuts in that month. Also note when the index fell below zero in December 2000 before slumping to a record low of -36.8 in February 2000, prompting two Fed cuts in January 2001.The Philly Fed survey has now come in below zero in three out of the last 4 months, lifting our odds for a March rate cut to 70%.

Nonetheless, the combination of softening inflation and declining business activity may not manifest itself in currency markets in the coming two weeks due to irregular thin trade. And with the dollar showing a tale of two performances; mixed against the European currencies and decidedly positive against the yen, traders may remain hesitant in opening fresh dollar longs or shorts.

Our Weekly FX Forecasts

Our forecast expecting EURUSD below 1.30, USDJPY hitting 119 and GBPUSD hitting 1.9467 this week was in the right direction but not reaching target in case of EURUSD and GBPUSD. We estimated that Germany's IFO survey would run out of breath and trigger euro losses. Indeed, the EURUSD did close lower, reaching as low as 1.3111, but far off out target of 1.3070 and 1.300. USDJPY headed to 118.96 this week, in line with our expectations. As for GBPUSD, we modified our forecast in our daily strategy piece (Dec 21) for a 1.9550, which was missed by 10 pips.

Going forward, we expect prolonged EURUSD losses next week, with initial target at 1.3070 and 1.3040.

The AUDUSD daily chart shows negative signals via the stochastics where the K% line has just dropped below the D% line at the 65% point, suggesting further downside room. The other negative signal is shown in the bearish divergence in the MACD lines over the week. Finally, the long shadow in the candle down day suggests signals declines to continue early next week, targeting the 5-week trend line support at 0.7805, before attaining the 0.7780.


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