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Retail spending in the U.S. unexpectedly increased 0.3% in February after advancing a revised 0.1% in the previous month, while sales less autos jumped 0.8% during the same period to top forecasts for a 0.1% rise.

The breakdown of the report showed demands for electronic goods expanded 3.7% after widening 2.2% in January, with discretionary spending on clothing increasing 0.6%, while sales for motor vehicles slumped 2.0% following the 1.5% contraction in the previous month.

Indeed, the data encourage an improved outlook for the U.S. as the private spending remains one of the leading drivers of growth, and conditions are likely to improve going forward as the expansion in monetary and fiscal policy continues to feed through the real economy. However, the ongoing deterioration in the labor market paired with tightening credit conditions could lead households to keep a lid on consumption over the coming months, and the Fed may maintain its pledge to keep borrowing costs at the record-low of an “extended” period of time as policy makers aim to encourage a sustainable recovery.

Following the release, the USD/JPY showed an immediate reaction to the better-than-expected data, with the exchange rate crossing back above the 50-Day SMA (90.45) to a high of 90.96. However, as the 30-minute RSI crosses into overbought territory, the sharp rally appears to be tapering off ahead of the U. of Michigan confidence survey due out at 14:55 GMT.

DailyFX provides forex news on the economic reports and political events that influence the currency market.
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Japanese Yen: Speculation for Intervention to Intensify Ahead of BoJ

Fundamental Forecast for Japanese Yen: Bearish

- Current Account Surplus Widens on Rising Exports
– 4Q GDP Expands Less-Than-Expected
– Machine Tool Orders Jump at Record-Pace in February

The Japanese Yen continued to pare the sharp rally from February, with the USD/JPY crossing back above the 50-Day SMA (90.44) to reach a fresh monthly high of 91.08, and the exchange rate looks poised to test the 200-Day SMA (91.86) over the following week as Prime Minister Yukio Hatoyama pledges to temper the appreciation in the low-yielding currency. At the same time, Finance Minister Naoto Kan said that the government stands ready to intervene in the currency markets during a speech in front of the Diet, while Deputy Finance Minister Yoshihiko Noda argued that the economy remains “in a mild deflationary state” and assured to “pay attention” to the Bank of Japan interest rate decision next week as policy makers aim to balance the risks for the economy.

Moreover, central bank Governor Masaaki Shirakawa announced that the board will keep interest rates low in order to support the domestic economy, but noted that its liquidity injections has limited impact on inflation as he expects to see a moderate recovery this year. Nevertheless, BoJ board member Miyako Suda said that the “upside and downside risks for the economy are almost balanced” during a speech earlier this week, but went onto say that the outlook remains subject to high “uncertainty” as the private sector remains weak. As a result, he sees inflation to “keep falling around the current pace for the time being,” and argued that the government will need to make “structural reforms” to encourage a sustainable recovery. However, Mr. Suda expects conditions to improve going forward as the expansion in monetary and fiscal policy continues to feed through the real economy, and said the central bank “will make persistent efforts to achieve sustainable growth with stable prices.”

A Bloomberg News survey shows all of the 17 economists polled forecast the BoJ to hold the benchmark interest rate at 0.10% next week, but market participants speculate the central bank to expand its emergency measures while maintain its JPY 19T balance sheet as the three-month bank-lending program from December is scheduled to expire at the end of this month. As policy makers continue to support the economy, expectations for an intervention could stoke additional downward pressures on the Japanese Yen, but a shift in risk sentiment could spark increase volatility in the exchange rate as the low-yielding currency continues to benefit from safe-haven flows. – DS

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Swiss Franc Vulnerable As SNB Threat Grows

Fundamental Forecast for Swiss Franc: Neutral

- Swiss National Bank leaves benchmark rate unchanged at 0.25%
– Consumer Prices Decelerated to 0.9% from 1.0%, despite a 0.1% increase in February
– The Swiss unemployment rate fell to 4.4% from 4.5%, but was unchanged at 4.1% on a seasonally adjusted basis.

After starting the week on a choppy note the Swiss Franc saw its appreciation begin to accelerate despite the SNB reaffirming their commitment to prevent excessive franc appreciation. The statement came following the central bank’s policy meeting where they left the benchmark rate unchanged at 0.25%. Building optimism and an unexpected surge in Euro-zone industrial production were the main drivers of Franc support to end the week. The Swiss unit has tracked the single currency as its economic fortunes are dependent on the Euro-area’s recovery. Policy makers have looked to limit the local currency’s appreciation against the Euro but despite the threat of intervention the EUR/CHF closed below 1.4600 for the first time in over a year. The Franc also reached the highest level in a month against the dollar and yen as markets reversed the flight to safety flows generated by the issues in Greece.

The Swiss National Bank raising their forecasts for inflation and growth also helped generate bullish Franc sentiment. Consumer prices are expected to grow by 0.7% in 2010 up from their previous forecast of 0.5%, eventually accelerating to 0.9% in 2011. However, the SNB did caution that the danger of deflation can’t be entirely ruled out which has them on alert to defend any excessive Franc appreciation against the Euro. The central bank also bolstered their outlook for growth to 1.5% from 0.5%-1.0%, as they see tangible signs of a recovery. Swiss consumer prices decelerated from 1.0% to 0.9% in February despite a 0.1% increase during the month, justifying the central banks concerns.

A continuation of risk appetite should see further Franc gains against the dollar and Yen. However, signs that returning growth is fueling broader inflation could raise interest rate expectations. The FOMC rate decision may be the biggest event risk for the Swiss unit as rising interest rate expectations will weigh on the outlook for growth, generating risk aversion. The domestic economic calendar isn’t typically market moving with export data and the SECO forecast the highlights. The Swiss trade balance report for February will provide the temperature for foreign demand and whether the pace of the recovery is sustainable. SECO forecasts will be compared to those of the central bank and major discrepancies could alter sentiment and the outlook for monetary policy. Of course the wild card is possible SNB intervention, especially with the EUR/CHF testing the levels that were seen when the central bank made its major move in March, 2009-JR

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Volatility perked up modestly for the active NYMEX crude contract Friday such that the market would test a new eight-week high of $83.16 before reversing course and potentially forging a bearish breakout. With the week’s close pulling the market below a trendline that has guided the commodity upward for over a month now, a speculative barrier has been removed. What is needed now is momentum; and such

North American Commodity Update

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There is a growing divergence in the state of the financial market’s fundamentals and its general level of activity. In the past week, there have been developments that have degraded the fidelity of the Euro Zone, leveraged the threat of a financial crisis in China and added risk to the very assets that are used to establish risk-free returns.

o Price Action Points to a Bullish Breakout but Market Fundamentals May Force a Collapse
o Greece, China and Global Sovereign Credit Ratings are but a Few of the Threats to Stability
o The US Dollar Slips without Confirmation of Risk Appetite from Commodities or Equities

There is a growing divergence in the state of the financial market’s fundamentals and its general level of activity. In the past week, there have been developments that have degraded the fidelity of the Euro Zone, leveraged the threat of a financial crisis in China and added risk to the very assets that are used to establish risk-free returns. However, the benchmarks for speculative positioning have either held their ground or maintained a gradual advance in favor of growth and yield. How can this dichotomy exist and when will it rectify itself? Assessing the situation objectively, it is possible to quantify the complacency of the market. Looking at traditional volatility measures, the S&P 500’s VIX Index is hovering just off of its lowest level since May 2008 while the currency equivalent currently stands at an 18-month low. Another approach to appraising activity is through calculating the average daily range of different markets. This measure of price action shows the Dollar Index just nearing an August 2008 low, crude easing to levels of lethargy last seen in September of 2007 and the Dow Jones Industrial Average just off of an average daily range not witnessed since the beginning of 2007. For changes in value itself, both equities and crude have advanced at a steady clip while the benchmark currency has essentially made no progress in over a month. Which is the better reflection of sentiment? The currency market. The notable appreciation in stocks and commodities is undeniable; but this has taken place within the confines of a broad range. Both the Dow and crude have prominent swing highs that were set back in January; and neither has yet to contest their respective milestones in this climb. When conviction in trend is revived (be it bullish or bearish), the correlation between these markets will return and there will be little doubt as to the market’s intentions.

On the other hand, it is not difficult to mark the return of volatility. It is, however, difficult to establish the direction the risk appetite and positioning ultimately take with this resurgence. Over the past month, the evidence of a move towards speculative position building has been made abundantly clear through the appreciation of the commodity and financial instruments (stocks and bond yields). Yet, in contrast, the economic and speculative arguments to be made for assuming greater risk have deteriorated over the same period. The greatest concerns can be split into two categories: issues that are currently influencing the market’s normal functioning and those threats that have yet to mature. The headline for the former column is the uncertainty surrounding the Euro Zone. The clearing in market volatility itself seems to have prevented a crisis with Greece as risk premium demanded for the nation’s debt have deflated. However, this is a fragile calm that could easily be broken by a shift in the currents of investor sentiment. And, considering the wide skepticism over the possibility of a European Monetary Fund, the national strikes in Greece and the reality that it will take significant suffering for EU nations to return to respectable levels of growth and indebtedness; balanced investor sentiment is all the region has going for it. The list of potential threats is long and growing. In China, recognizing the trouble that property speculation and lending have raised for the economy, the government vowed regulation and nullified all loan guarantees made by local government. This second effort is particularly worrying because it opens the doors to a wave of defaults as activity does cool. Other pending issues include the rating agencies’ warnings to the UK about its banks’ credit ratings, government stimulus withdrawal and global sovereign debt ratings.

Is Carry Trade and risk appetite rising or falling? Discuss how to trade yields and market sentiment in the DailyFX Forum

Risk Indicators:	Definitions:
	What is the DailyFX Volatility Index: The DailyFX Volatility Index measures the general level of volatility in the currency market. The index is a composite of the implied volatility in options underlying a basket of currencies. Our basket is equally weighed and composed of some of the most liquid currency pairs in the Foreign exchange market. In reading this graph, whenever the DailyFX Volatility Index rises, it suggests traders expect the currency market to be more active in the coming days and weeks. Since carry trades underperform when volatility is high (due to the threat of capital losses that may overwhelm carry income), a rise in volatility is unfavorable for the strategy.
	What are Risk Reversals: Risk reversals are the difference in volatility between similar (in expiration and relative strike levels) FX calls and put options. The measurement is calculated by finding the difference between the implied volatility of a call with a 25 Delta and a put with a 25 Delta. When Risk Reversals are skewed to the downside, it suggests volatility and therefore demand is greater for puts than for calls and traders are expecting the pair to fall; and visa versa. We use risk reversals on USDJPY as global interest are bottoming after having fallen substantially over the past year or more. Both the US and Japanese benchmark lending rates are near zero and expected to remain there until at least the middle of 2010. This attributes level of stability to this pairs options that better allows it to follow investment trends. When Risk Reversals move to a negative extreme, it typically reflects a demand for safety of funds – an unfavorable condition for carry.
	How are Rate Expectations calculated: Forecasting rate decisions is notoriously speculative, yet the market is typically very efficient at predicting rate movements (and many economists and analysts even believe market prices influence policy decisions). To take advantage of the collective wisdom of the market in forecasting rate decisions, we will use a combination of long and short-term, risk-free interest rate assets to determine the cumulative movement the Reserve Bank of Australia (RBA) will make over the coming 12 months. We have chosen the RBA as the Australian dollar is one of few currencies, still considered a high yielders. To read this chart, any positive number represents an expected firming in the Australian benchmark lending rate over the coming year with each point representing one basis point change. When rate expectations rise, the carry differential is expected to increase and carry trades return improves.

Additional Information

What is a Carry Trade
All that is needed to understand the carry trade concept is a basic knowledge of foreign exchange and interest rates differentials. Each currency has a different interest rate attached to it determined partly by policy authorities and partly by market demand. When taking a foreign exchange position a trader holds long position one currency and short position in another. Each day, the trader will collect the interest on the long side of their trade and pay the interest on the short side. If the interest rate on the purchased currency is higher than that of the sold currency, the result is a net inflow of interest. If the sold currency’s interest rate is greater than the purchased currency’s rate, the trader must pay the net interest.

Carry Trade As A Strategy
For many years, money managers and banks have utilized the inflow and outflow of yield to collect consistent income in times of low volatility and high risk appetite. Holding only one or two currency pairs would invite considerable idiosyncratic risk (or risk related to those few pairs held); so traders create portfolios of various carry trade pairs to diversify risk from any single pair and isolate exposure to demand for yield. However, even with risk diversified away from any one pair, a carry basket is still exposed to those conditions that render this yield seeking strategy undesirable, such as: high volatility, small interest rate differentials or a general aversion to risk. Therefore, the carry trade will consistently collect an interest income, but there are still situation when the carry trade can face large drawdowns in certain market conditions. As such, a trader needs to decide when it is time to underweight or overweight their carry trade exposure.

Written by: John Kicklighter, Currency Strategist for DailyFX.com.
Questions? Comments? You can send them to John at jkicklighter@dailyfx.com.

DailyFX provides forex news on the economic reports and political events that influence the currency market.
Learn currency trading with a free practice account and charts from FXCM.