There are many reasons to believe that USD/JPY will head lower in the coming months, most of which center around the weak US and global economic outlook.

However there is one reason why we could see a turn, and that is the correlation between USD/JPY and the VIX (which measures the volatility in the equity market). Usually when the VIX (which is inverted in the following chart) rises, USD/JPY falls because high volatility tends to propel investors into the safety of the Japanese Yen.

The Swiss are going crazy because they can’t figure out what to do with their currency. Yesterday, EUR/CHF collapsed after SNB President Roth ruled out intervention. This morning, the currency pair has completely reversed its earlier losses because the Finance Minister said that the government would support the SNB in selling Swiss Francs.

It certainly smells like there are some political disputes over in Switzerland, which is never good for a currency. Either way, USD/CHF is in the buy zone and there is a lot of support around the 1.1375 to 1.1420 level. We could see a move up to 1.18.

The Euro and British pound sold off aggressively Thursday on the heels of comments from government officials and market players.

Risk aversion has been a theme in the markets following the weaker than expected jobless claims and durable goods report from the US (read my full insight on these numbers at FX360.com)

Like Florida weather, the Swiss National Bank can’t make up their mind about whether they want to intervene in the currency market or not. Last week, the Swiss franc collapsed after SNB Vice President Hildebrand said point blank that “they could also intervene in the currency markets to prevent “renewed appreciation” of the franc. Thursday morning SNB Roth shot down speculation about intervention by saying that he has yet to see the franc “overshoot” and there is no need for the central bank to intervene.

Physical intervention by the SNB was very unlikely since the central bank once did a study touting the effectiveness of verbal intervention. Furthermore, a study in 2003 revealed that the interventions of the SNB to strengthen the Swiss franc were more effective than its interventions to weaken the Swiss
franc.

The Federal Reserve has officially run out of room to cut interest rates. For the first time since August 2007, they left interest rates unchanged at a target range of 0 to 0.25 percent.

The dollar rallied because the Fed did the minimum of what was needed to pacify the market, which was to say that they could purchase Treasuries but are not going to do so right now.

The biggest mover Wednesday morning is the Canadian dollar which has rallied close to 300 pips against the US dollar and is closing in on the 1.20 level. What’s behind the move?

1. Major merger and acquisition flow. Mexican breadmaker Bimbo closed on a $2.38 billion acquisition of U.S. Bread making unit of Canada’s George Weston Ltd

On Friday, in my Daily Currency focus for FX360.com, I talked about the 3 Big Threats to the US dollar this week. One of them was a bad bank plan. Wednesday morning, Dow futures and higher yielding currencies are up sharply on news that Obama’s Administration has prepared a plan to create a bank that would absorb toxic bank assets. Here’s a recap of what I wrote on the plan and read the rest of the report for the other 2 major threats facing the US dollar.

Bad Bank Plan - There is no question that equities are still leading currencies for the time being and over the next few weeks, the Obama Administration could announce a plan to create an “aggregator bank” that would soak up the bad debt sitting on bank balance sheets. This would free up capital for the banks which would hopefully encourage lending and restore investor confidence. If Obama announces a bad bank plan, it could squeeze shorts in financial stocks and take the entire index higher. Since currencies are still moving in lockstep with equities, a rebound in stocks could help reduce risk aversion and take some of the steam out of dollar rally.

For the first time since August 2007, the Federal Reserve is not expected to change interest rates. With the fed funds rate now set to a target range of 0 to 0.25 percent, the Federal Reserve has maxed out on their most conventional monetary policy tool. Although they still have different ways of adding liquidity to the financial system and stimulating the economy, what was once the second most market moving event risk for the foreign exchange market could become a non-event.

Going forward, traders may have the same disregard for FOMC rate decisions as they do for Bank of Japan meetings. The only way for Wednesday’s FOMC rate decision to hurt the dollar would be if the central bank announces that they will be purchasing long term US Treasuries in size or if they add more ingredients to their alphabet soup of new programs. There is nothing to support the dollar on the upside as the Fed is not expected to start talking about raising interest rates.

In more than 40 years, we have never seen US consumers this pessimistic. The Conference Board’s report on consumer confidence fell to 37.7, the lowest level on record. The disappointing consumer confidence report will drag down risk appetite and drive investors into the safety of US dollars. The rally in the US dollar is a reflection of more panic selling and not optimism about US economy. On the heels of the report, we have already seen the EUR/USD and equities turn negative. We may not see a recovery in confidence until job security is no longer a major concern. Unfortunately with headlines in national papers touting the 74k jobs axed in one day Tuesday morning, consumers will not turn optimistic anytime soon. The one silver lining in the report is that we have seen an increase in plans to buy automobiles within the next 6 months. Major discounts are enticing consumers to buy new cars. Looking ahead, discounts and incentives will be the only for businesses to push inventory. Fourth quarter GDP is due for release on Friday and weak consumer confidence supports the market’s belief that growth was the weakest in 26 years.

Earlier Tuesday morning, S&P/CaseShiller reported that house prices fell 18.18 percent in the month of November, the largest decline on record. Unfortunately house prices still have room to fall as the labor market remains weak and more inventory floods the market over the next few months.

There is a lot of talk this morning that the Bank of Japan is checking currency rates. The Japanese Yen has continued to rise over the past 24 hours and by checking rates, the central bank is keeping a very close eye on where the Yen is trading. Given that it is almost 11pm in Japan right now on a Friday, the central bank is either very serious about intervening in the currency market or they want to keep currency traders on their toes. The 87.00 level for USD/JPY could very well be their breaking point. The risk of intervention is limiting the decline in USD/JPY on a day when the sharp drop in Dow futures should be driving it much lower. Over the past 6 months, we have seen a significant appreciation in the Japanese Yen to the point where the central bank can no longer ignore it. For example, the Yen has risen more than 40 percent against the British pound, Australian and New Zealand dollars.

The rebound in the foreign exchange market on Wednesday was short lived as another wave of risk aversion hit currencies. US economic data was very weak with jobless claims rising to the highest level since 1982 and housing starts dropping 15.5 percent to the worst level ever. Starting with the labor market, continuing claims, which measure the number of people remaining on unemployment rolls rose to 4.607 million. So far we have seen 12 consecutive months of negative non-farm payrolls and as long as claims remain above 500k, we will continue to see net job losses in the US economy. If a bellwether like Microsoft (MSFT) can announce that they are planning to cut 5000 workers, more companies will follow suit especially smaller ones who may not have rainy day funds to weather the storm. In past recessions job cuts have lasted for a minimum of 15 months which means that non-farm payrolls may not turn positive until the second half of the year.

The housing market is crippled by the falling consumer wealth and tight credit markets. Even potential homeowners who actually have the money to by are having a very difficult time obtaining financing. Good credit ratings don’t really matter any more. with so much inventory still on the market, housing starts and building permits should continue to drop.

There was a lot of volatility in the foreign exchange market Wednesday morning, driving currencies to historic levels:

GBP/USD - 26 Year Low
USD/JPY - 13 Year Low
NZD/USD - 6 Year Low
EUR/JPY - 6 Year Low
CAD/JPY - 13 Year Low
GBP/JPY - Record Low
NZD/JPY - 8 Year Low

In my Daily Currency Focus for GFT I talked about how Obama’s first 100 days can impact currencies:

In Tuesday’s Daily Currency Focus we warned that investors should not bank on an Obama bounce. Based upon 5 decades worth of data, the Dow Jones Industrial Average fell more often than it rose on Inauguration Day. In fact stocks fell more on Barack Obama’s Inauguration Day than any other President. Since currencies are taking their cue from equities, we have seen a sharp slide in almost all of the major currency pairs. The dollar has outperformed the Euro and British pound but it has declined against the Japanese Yen indicating that the dollar’s rally is a reflection of pessimism and not optimism. We are seeing a flight to safety into US dollars but bonds are the instruments of choice and not equities.

The British pound has fallen to a 7-year low against the US dollar and a record low against the Japanese Yen. Over the past 3 trading days, the GBP/USD has dropped more than 1000 pips or 7 percent. Consumer prices were hotter than the market expected, so what has fueled this aggressively selling?

One answer - FEAR

The Bank of Canada cut interest rates to 1.00 percent, the lowest level ever for the 75 year old central bank and signaled that they could bring interest rates down to US levels. The historic move was motivated by the sharp downturn in the US economy and the continual slide in oil prices. Not only are Canadians making less, but they are seeing their household wealth plummet as well. The Canadian economy is not expected to grow in 2009, which is why more rate cuts are needed. The BoC is far from done and could realistically match US rates. Inflation is not a problem since they consumer prices are expected to be negative for the next 2 quarters

The Canadian dollar has already sold off aggressively ahead of the Bank of Canada’s interest rate decision. It has stalled in the minutes after the announcement but should continue lower in the days to come.

On Tuesday, the United States of America will swear in a new President. Unlike many other Presidents in the past, the Obama phenomenon spans the globe. This global support has spurred speculation that we may see an Obama Bounce in US equities and currencies on Tuesday. However based upon the past price action of the Dow Jones Industrial Average on Inauguration Day (Jan 20), investors should think twice about an Obama Bounce.

Taking a look at 50 years' worth of data which spans 10 Presidents, Inauguration Day results in more down days than up. The Dow fell on January 20th 12 out of the past 16 Inaugurations. Although the trend was much more significant in the 60s and 70s, it has been relevant since then. The pattern also does not hold any bias to the party of the new President as exactly half of the positive days occurred during either party's new administration.

Monday morning, Standard and Poors downgraded the sovereign debt rating of Spain from AAA to AA+. With Greece’s rating downgraded last week and Ireland and Portugal on credit watch negative, this could be the beginning of more downgrades.

Therefore it is important to consider what it means for a country to have their credit rating downgraded:

With the US markets closed for Martin Luther King’s Day, the odds were skewed towards a quiet trading. However, big news in Europe has made it anything BUT quiet.

After hitting an intraday high above 1.33, the EUR/USD has sold off aggressively on news that Standard and Poors downgraded the sovereign debt rating of Spain from AAA to AA+. The outlook is stable which means that further downgrades for the country is unlikely. However this could be the beginning of more downgrades in the Eurozone. Last week, Greece’s sovereign debt rating was downgraded as well to A- while Ireland and Portugal have been placed on credit watch. The reasons for the downgrades are obvious. The Eurozone is in recession and those countries have suffered greatly. Also, public finances have deteriorated materially since the governments are trying to spur growth by spending.

The theme in the markets Friday morning is a return of risk appetite. The US government has bailed out Bank of America (BAC) for the second time, reminding investors that they are still here and ready to help the banking sector. BoA received another $20B to ease their absorption of Merrill Lynch (MER). So far, they have received $138B in government aid even though their market cap is only approximately $50B. The additional funds provided to BoA is the only reason why the dollar is rallying against the Japanese Yen and why we are seeing a recovery in all of the higher yielding pairs such as the EUR/USD and GBP/USD.

As for Friday morning’s economic data, consumer prices continued to fall, foreign demand of dollar denominated investments was the weakest since September 2007 and industrial production fell for the fourth time in five months. The overwhelmingly dollar bearish news only had a limited impact on the dollar because much of the bad news has already been baked in. Most people are expecting a weak set of economic data this month. The bigger surprises will come from earnings which is why we are keeping a close eye on equities.

After having cut interest rates by 50bp Thursday morning to 2 percent, ECB President Trichet is finally buckling down and signaling that he is ready to cut interest rates again BUT NOT UNTIL March. Despite the weakness in the economy and softer inflation pressures, the hawk in Trichet refuses to die. By saying that the Feb meeting will not be important suggests that pausing is still an option. The next meeting that matters is in March at which the ECB will release new projections. The Feb meeting is only 3 weeks away but by March, they will have a lot more economic data to base their decisions. The possibility that the ECB could leave interest rates unchanged next month is driving the Euro higher. We will probably see the Euro recover for the rest of the week but it is important for FX traders to realize that Eurozone interest are still coming down. Zero interest rates is not an option but the terminal rate for the ECB is likely to 1.25 percent.

Up until now, Trichet’s biggest concern is price stability and for the first time in this easing cycle, he believes that the risks to price stability is broadly balanced. This is a big shift for the central bank and one that should not be ignored. The 50bp rate cut Thursday reflects weaker growth and lower inflation risks. A lot has changed since the last meeting as the problems in the Eurozone economy worsen. Not only is the region in recession but many countries are at risk of getting their sovereign debt rating downgraded. Greece’s credit rating was cut by S&P yesterday. There are no silver linings for the Eurozone. Unemployment is rising and consumer spending is contracting. According to the Trichet, the risks to growth are certainly to the downside Eurozone governments will have to dig deeper into their own pocketbooks to deliver enough fiscal stimulus to turn their own economies around. Over the next few months, we expect weaker economic data that provides more of evidence of the continual slowdown in the Eurozone economy.