Fed Throws Dollar to the Dogs – 1.45 Next?

After weeks of consolidation during which the EUR/USD churned between 1.33-1.38 dollar bears finally had their day as the pair broke through the key psychologically important 1.40 level aided in no small part by Fed’s decision to cut rates by 50bp rather than the market consensus 25bp. Clearly FOMC members took a calculated risk to err on the side of higher inflation rather than lower economic growth. With credit markets still fragile and housing markets continuing to contract, the Fed decided that simulative action was necessary even if it further weakened the greenback.

Despite record highs in oil and gold, the core CPI rate remained relatively low at 0.2% month over month gain and for the time being the Fed’s action looked wise as the yield curve steepenned and equity markets rallied to within striking distance of all time highs. After all a weaker dollar helps US exports which should contribute positively to GDP growth in Q3. However, the Fed’s strategy carries one great danger. If low interest rates markedly decrease the flow capital to US, the dollar becomes vulnerable to a panic sell off. With near 1 Trillion Current Account deficit US is highly depended on foreign capital flows to finance its consumption and growth. Last week’s shocking decline in TICS data may have been the first sign that foreigners are losing appetite for US debt. While one month does not make a trend, the TICS could become much more important in the upcoming months if the dollar remains under assault.

Next week, markets will focus on the latest housing data as well as consumer sentiment, but perhaps the most important event risk will take place on Wednesday as traders await he Durable Goods report. If Durables surprise to the upside the dollar may catch a break as the bleakest of forecasts regarding US economic demand will prove premature. However, should the data show yet another disappointing result the dollar may weaken further as traders will begin pricing in yet another rate cut before year end.

Euro Barrels Higher But Can it Sustain the Gains?

The Euro barreled through the 1.40 level last week as significant weakness in the US Dollar pushed the EURUSD pair to record highs of 1.4120. Economic data did very little to underpin gains for the pair, as the results proved to be weaker than expected. First, the seasonally adjusted Euro-zone trade balance surprisingly fell into a deficit during the month of July as the appreciation of the Euro hinders purchases of European exports. Furthermore, import growth accelerated quite a bit with the help of higher oil prices and strong domestic demand. There are emerging signs that consumption in the Euro-zone could slow, however, as the ZEW survey of economic sentiment unexpectedly plummeted to a reading of -20.3. The surge in pessimism was somewhat warranted, as investors were faced with volatility in the financial markets and continued hawkish commentary by European Central Bank members signaling another potential rate hike. However, with Euro-zone CPI now well below the ECB’s 2.0 percent ceiling and the downside risks to growth slowly increasing, it may be entirely unnecessary for the central bank to tighten monetary policy, if not completely counterproductive. As a result, EUR/USD could be in for some widespread selling as traders start to speculate that the ECB’s tightening cycle is complete.

Looking ahead to this week, the economic data on hand isn’t likely to make much of an impact on EUR/USD trade, as US Dollar flows will likely remain the driver of the pair. The Euro may be plagued by more disappointing sentiment reports, as both the IFO Business Climate and the GfK Consumer Confidence surveys are scheduled to be released. There is little hope for improvements in either figure, as investors and consumers alike will be increasingly concerned about the prospects for growth in the Euro-zone. Indeed, it appears that the European economy could be teetering on the brink of deterioration, and if we start to see European Central Bank members ease up on some of their hawkish rhetoric, EUR/USD bulls may start to pay heed and take the pair back below 1.40.

Yen Drawn Between the Carry Crowd and Dollar Void

Clearly the FOMC’s decision to cut its benchmark lending rate 50 bp rippled across the currency markets last week. And, for the USD/JPY major, this policy shift had a duel effect. On the one hand, the sharp drop in the dollar created a vacuum for yen bidding to fill. However, USD/JPY certainly did not see the same massive anti-dollar move that the other majors reported. This was because the yen pair has traded as a proxy for overall risk – with a particularly close correlation to the health of equities. Consequently there was clear tug of war in the pair as the masses were confused over whether the cut was a major blow to its considerable rate differential or if it would stabilize market volatility enough to revive risk appetite and the carry trade. Ultimately, this battle would not be resolved by the end of the day. Interestingly enough, the Bank of Japan delivered its own rate decision just a short time after Fed Chairman Ben Bernanke surprised the market. As many had speculated, BoJ Governor Toshihiko Fukui said the downside risks to the US economy and unstable global financial markets would be a hindrance to any further rate hikes out of Japan. And, though it went unsaid, the Fed’s cut may signal an end to global hawkishness.

Aside from the central bank activity this week, there were a number of upper crust indicators attracting fundamental traders back to the economic calendar. Sizing up next week’s retail trade report, the nationwide and Tokyo department sales figures put up a strong showing. Elsewhere, the All Industry Activity Index for July fell 0.4 percent in line with expectations primarily due to industrial productivity disrupted by earthquakes and unruly weather impacting the retailing and tertiary sectors. These numbers aside, the top data point for the week was the Ministry of Finance’s BSI sentiment index for the third quarter. A sharp rebound in optimism among large manufacturers was based on confidence that the economy would find traction; yet this clearly did not encourage business leaders enough to increase planned spending.

Looking to the scheduled economic activity ahead, fundamentals will definitely guide price action should the volatility and risk aversion/acceptance trends continue to moderate. The front half of the week is relatively light. Supermarket sales, the merchandise trade balance and small business confidence reports will garner little interest. The real action begins Friday morning in Tokyo with the usual consumer/inflation indicator pack. The National and Tokyo CPI figures for August and September respectively are expected to hold firmly in negative territory, which would further depress any lingering hope of a nearby rate hike. The retail sales, household spending and employment numbers will be the true question mark for the period though. They will be the first test of optimistic growth projections.

Pound Recovers Though 6.00% Seems Out of Reach

Bank of England Governor Mervyn King, like his US counterpart Federal Reserve Chairman Ben Bernanke, was grilled by government officials last week over his handling of the ongoing credit crunch. More specifically, the Commons Treasury Select Committee’s quizzing was focused on how the Northern Rock situation had gotten so out of hand. King was not unprepared though. He defended the BoE’s actions saying legislation ultimately tied his hands on his ability to handle the situation. The Governor said he would have preferred to be a ‘covert’ lender of last resort (LOLR) or usher a quiet sale, but that take over laws and other rules had prevented such solutions. He went on to reiterate his strong stance against the ‘moral hazard’ of bailing banks out their own, poor investment and lending decisions. King made similar assertions in a letter to Select Committee chairman John McFall a week before in which he said he was reluctant to inject the market with liquidity. However, doubts over the entire British banking system moved policy makers to promise to provide tens of billions of pound in three-month loans. This was in addition to the BoE’s and Government’s pledge to guarantee all Northern Rock clients’ savings; though neither party made it explicitly clear whether the same level of protection would be extended to the customers of any other bank or financial firm that fell on hard times. These accommodative steps towards the simmering problem in the financial market, along with cautious minutes from the September 5 and 6 meeting, raise a real concern that the MPC has reached the end of its rate increases and may even entertain the probability of a cut should market conditions worsen.

Looking at the list of indicators scheduled for release over the coming days, it seems as if there will be little fundamental head wind to carry the pound through 2.0 the dollar mount a defense. The first noteworthy indicator to hit the wires is the final reading on second quarter GDP. Economists expect the annual and preliminary readings to hold fast with a 0.8 percent rise for the quarter and 3.0 percent through the year. The current account balance for the same period, on the other hand, will be an unknown for event traders to worth with. The deficit is expected to contract for the second consecutive quarter after hitting a record in the final months of 2006. On the following day, the Nationwide Building Societies housing prices report for September will give another weigh in on the health of the residential housing market. This follows a 2.6 percent drop in the Rightmove indicator, the steepest since 2002. Considering the Bank of England is just coming off of five rate hikes, the credit market is still fragile and consumer sentiment has been unsettled by the Northern Rock run, the UK housing market may follow the US residential sector on a deep pull back. Finally, Friday will bring the September GfK Consumer Confidence survey. The official consensus is already calling for a step down in optimism, though given the growing fears of a stability of the banking and lending system, it would not be surprising to see something worse than expected.

Swiss Franc Sets Multi-year Highs on Interest Rate Outlook

The Swiss Franc set fresh multi-year highs against the downtrodden US dollar, with improved interest rate differentials boosting the Swissie’s stance against the greenback. Given the Fed’s surprise decision to cut interest rates by 50 basis points, traders’ focus immediately turned to the dollar’s narrowing yield advantage over the CHF. The US dollar is expected to fall further through the medium term, as clear expectations for further interest rate cuts can only worsen the buck’s stance across the board. In contrast, the Swiss Franc’s yield curve shows steadily rising rate expectations through the period. This alone may be enough to keep the Swissie bid, but we nonetheless feel that overextended positioning may be enough to force a short-term retrace in the USDCHF. According to our technical analyst Jamie Saettele, the pair may correct before a fresh wave to new lows.

Fundamental data proved a mixed bag through the past week of trade, as disappointments in business sentiment offset positive results in inflation data and domestic production. The Swiss ZEW survey fell significantly below consensus forecasts for the month of September, reflecting a pessimistic outlook on the future of economic conditions. The net implications of such a result are bearish for expansion, but robust second quarter Industrial Production data nonetheless shows that the economy remains on solid footing. A slightly higher than expected Producer and Import Price inflation figure subsequently boosted outlook for domestic interest rates. Given a relatively hawkish Swiss National Bank, any signs of increased price pressures can only increase speculation for rising interest rates for the CHF.

Upcoming event risk will include the typically market-moving KOF Leading Indicator and UBS Consumption report. Both are forecast to show a moderate slowdown in growth, with recent financial market troubles spreading to other sectors of the economy. Yet positive surprises in said figures could easily prove that Switzerland remains isolated from the global credit crunch. Outlook on the Swiss Franc subsequently will depend on the results from the KOF data, with risks arguably remaining to the upside ahead of the release.

Canadian Dollar Hits Parity, Can this Record Run Continue?

Not only did the Canadian dollar hit a new 31-year high against the benchmark greenback, it has had done the unthinkable and reached parity. Extending the break below 1.0475 on September 11th, USDCAD dropped slid another 360 points last week to find a low of 0.9935. Of course, such a milestone could not pass without a policy maker weighing in. Finance Minister Jim Flaherty made a rare comment about the Canadian currency stressing its strength was primarily due to the severe slump in the US dollar and not a reflection of strong developments in the economy. He was so concerned in fact that he made a call to Bank of Canada Governor David Dodge, though he would not divulge the contents of their conversation. However, other politicians have not been shy in their demands to Dodge. The Canadian Labour Congress urged the central banker to follow the Fed’s lead and cut the benchmark lending rate 50 basis points to prevent layoffs in the manufacturing sector that are likely to evolve as exporters suffer from the stifling exchange rate with the nation’s largest trading partner.

While Dodge and his fellow policy makers mull over their options, it is worthwhile to take a look at last week’s economic indicators. The Fin Min.’s comments that the currency is not running on Canadian economic fuel seemed to be fully encompassed in two top tier releases: the consumer inflation index and retail sales report. The CPI’s climb to highs set only a few months ago was certainly the final component for encouraging the BoC to hike the overnight lending rate a quarter percent back in July to 4.50 percent. However, since hitting its highs inflation pressures have fallen back considerably. The headline CPI gauge cooled to a 1.7 percent annual pace, the weakest in eight months and well below the policy group’s 2.0 percent target. While the core figure didn’t allow for the same volatility, even with the exclusion of the considerable drop in gasoline prices, it still cooled unexpectedly to a 2.2 percent gait. Further adding to the turn in economic fortunes, consumer spending was obviously delivered a blow by expensive gas prices and higher interest rates. A 0.8 percent drop in retail sales threatens the engine of the Canadian economy: domestic spending.

Over the coming week, there is only one economic landmine to disrupt the market’s natural flow; but it a doozy. The July gross domestic product figure could lend further credibility to the comments Fin Min Flaherty’s made last week about steady growth that does not warrant a the loonie’s recent highs. As it stands, projections are aiming high looking for a 0.4 percent jump in growth that would double June’s improvement. However, should this indicator miss its mark, the policy makers words will likely ring loud in traders’ ears and take some of the air out of the Canadian currency. Indeed, with USD/CAD as such incredible lows, sentiment will become a balancing act. Every piece of scheduled data, official comment or commodity fluctuation could potentially drive the next leg of the loonie’s run, up or down.

Australian Dollar Shows Few Signs of Slowing Advance

The Australian dollar retraced significant ground against its downtrodden US namesake, as improved interest rate differentials boosted demand for the carry trade-linked currency. A surge in gold prices likewise helped drive the Aussie higher, with a bullish outlook for the precious commodity translating to currency gains. We remain bullish the currency through the medium term, but our own technical analyst Jamie Saettele believes that the pair may experience a correction to the 0.8492 mark before resuming its advance. From a more fundamental perspective, recent economic data may likewise represent a hurdle to further runs higher.

A sharp drop in August HIA New Home Sales reflects that recent credit market troubles may significantly dent recent Aussie real estate gains, casting a similarly dark shadow over the future of domestic consumer spending. A simultaneous New Motor Vehicle Sales report supports this argument, as the headline number fell a whopping 1.9 percent through the same period. Automobile sales remain robust at a 8.0 percent year-over-year pace, but the recent report certainly suggests that the trend may turn lower on a jump in market interest rates.

The coming week of economic data may shed further light on the future of consumer spending, with a Private Sector Credit report to headline event risk for the Aussie dollar. Analysts predict that the net amount of private sector debt grew by 1.0 percent through the period—hardly indicative of slowing demand. Yet a disappointment in the number could confirm concerns and heighten pessimism on domestic lending markets. Other important economic data includes a Job Vacancies report due at 00:30 GMT on September 27. Though the second-tier report does not typically force major moves across Aussie pairs, the leading indicator for employment growth could nonetheless give insight on the future of labor trends.

Can the New Zealand Dollar Hold Recently Gained Ground?

The New Zealand dollar regained significant ground against its US namesake, as a greenback rout pushed the NZD/USD to monthly highs. Kiwi advances likewise dragged the AUD/NZD substantially off of its September peak, and the NZD/JPY rallied an impressive 370 points off of Sunday’s open. New Zealand’s impressive 8.00 percent yield proved to hard to resist as yield-hungry investors kept the currency bid. Yet such overwhelming demand for domestic interest rates leaves the currency highly susceptible to swift declines on a recurrence of a carry trade liquidation. Rallies across risky global asset classes have kept the carry trade afloat through recent trade, but we remain unconvinced that this marks the turn in the popular trading strategy’s performance.

The past week of economic reports showed surprisingly bullish signs in both Credit Card Spending and Current Account balance, improving the Kiwi’s status among major foreign counterparts. The former showed that spending remained robust in the small island economy, with seasonally-adjusted growth advancing to 8.4 percent through July. The latter demonstrated a better-than-expected external balance of payments for the broader economy. The highly-publicized New Zealand Current Account deficit certainly remains a detriment to the sustainability of New Zealand dollar gains, but it appears markets remain relatively unconcerned with the below-forecast second quarter result.

The upcoming week of event risk will likely cause modest volatility across all NZD pairs, with Q2 Gross Domestic Product results due at on September 27 at 22:45 GMT. Given the extensive delay in time of reporting, the number may not prove quite as significant as one might expect. Clearly, however, any large surprises could easily spark volatile moves in the domestic currency. Earlier Trade Balance and Building Permits results may likewise spark pronounced moves in the Kiwi, as markets remain sensitive to both domestic housing and international trade figures. Outlook for the New Zealand dollar subsequently depends on upcoming economic event risk, with the trio of GDP, Trade, and Housing numbers to influence sentiment on the overall economy.

Boris Schlossberg is a Senior Currency Strategist at FXCM.