Dollar: Will The Rally Continue To 1.50?

The greenback put up its best week in 3 years rallying nearly 5 big figures in five days as market expectations regarding US interest rates changed dramatically. As we noted in our special report Fed Rate Hike Ready or Not regarding Chairman Bernanke uber hawkish remarks last week, “This was a tremendous change in tone from the Fed Chairman who for the past 18 months has spent most of his energy combating the negative economic effects of the housing bust and the credit crunch by methodically lowering rates from 5.25% to 2.00%. Clearly the game has changed and the Fed now felt that inflation was a bigger problem than growth for the US economy.”

Inflation of course is being driven by oil and the Fed has taken square aim at crude by suggesting that US monetary policy will become restrictive in order to retrain the rising prices of petroleum. This week-end’s G-8 meeting addressed the same issue with member nations providing a strongly worded communiqué asking oil producers to put out more product. In response reports out of Saudi Arabia indicate that the swing OPEC state has agreed to pump out an extra 500K/bbl per day. If that report proves true and manages to push oil process below $130/bbl the greenback should strengthen further at the start of trade next week. G-8 however, shied away from any overt language regarding exchange rates, leaving US Secretary of Treasury Paulson to simply reiterate the well worn mantra that US is committed to a strong dollar.

Next week the calendar contains only 2nd tier economic data with only PPI release having much of an impact on the market. In short, the macro factors that drove trade last week as likely to continue to play an important part this week with all eyes focused on oil prices. The greenback had a powerful change of turn last week and unless US data produces major negative surprises in the smattering of Industrial gauges due this week, the path of least resistance in the EUR/USD appear to be down.

Euro: Trouble In Paradise

Despite a very impressive week of economic data that saw surprisingly better results in Trade Balance and Industrial Production figures, the euro took a drubbing which ended on a final depressing note on Friday when Ireland rejected the Lisbon Treaty, once again throwing the whole issue of EU Constitution into a state of flux. As our colleague Kathy Lien noted, “As the European Union’s second attempt at a constitutional treaty, in some ways it deals a significant blow to the EU but in some ways, it does not. Recall what happened in 2005 when the French and the Dutch rejected the proposed EU Constitution Treaty. The Euro weakened, there was a lot of panic and fear about the viability of the single currency but eventually, the Euro erased all of its gains and then some when traders realized that the single currency is here to stay. The same can be said this time around. The EU Constitution is at risk and not the European Monetary Union. The EU can still function under its existing agreements and with over 50 percent of all member states having already ratified the treaty (a unanimous vote was needed for it to passed), France’s Europe Minister believes that a separate legal agreement will be arranged with Ireland so that a no vote by one country does not hold hostage the 26 other member states.” Nevertheless, the political schism that is quickly developing the EZ between Northern and Southern economies is clearly creating enough tension that it now puts the idea of a possible ECB rate hike next month into question.

Much like US the economic calendar in EZ is virtually void of any meaningful data with only the EZ CPI numbers and ZEW on the docket. The inflation numbers may provide a temporary boost if they print hotter than expected but the question still remains if that data will be enough to push the ECB to hike rates in July. On the other hand a cooler read could trigger yet more euro selling as currency traders will start to discount President Trichtet’s hawkish talk from two weeks ago, minimizing any chances of a rate increase.

Yen Falls On Dovish BoJ And Hawkish Bernanke

A dovish BoJ following a rate hold at 0.50% would propel the USD/JPY to test resistance at the 200 Day SMA at 108.30. The pair made a steady climb throughout the week as risk appetite and dollar bullish sentiment was fueled by comments from Fed Chairman Ben Bernanke to start the week. Bernanke said late Monday that the likelihood of a severe US economic slump has diminished, while "upside risks" to inflation were forcing the Fed to be more vigilant in monitoring prices. The comments overshadowed better than expected GDP and machine orders prints. However, The Japanese Eco Watchers Index fell to 32.1 from 35.5, far below expectations of a 34.0 reading. Sentiment for Japanese merchants dropped for a second month as rising inflation continues to diminish consumer’s purchasing power. The Japanese economy which is already seeing a slowdown from declining U.S. demand may not be able to count on domestic spending to drive the economy.

Indeed, Governor Masaaki Shirakawa noted that growth was slowing due to rising fuel and raw material costs. He stated, "We now, therefore, need to assess if and how a weakening of the income growth momentum, stemming from the deterioration of the terms and conditions of trade, will pose downside risks to domestic private demand ... how expectations on inflation and how the price-setting behavior (by companies) hold the key to deciding how we should manage our monetary policy,' Although the central bank is monitoring prices they also felt that the Japanese economic and price conditions were different from those in the United States and Europe. This may signal that the BOJ has no intention of increasing rates in the near-term.

Risk sentiment will drive the pair this week again. Although, the economic docket will present a significant event risk in the Tertiary Industry Index. The measure of the service sector historically is market moving as the it accounts for the majority of GDP. A dour reading may see the pair break through the 200-Day SMA and test the 50.0% Fibo 124.16-95.78 resistance at 109.94, where a better than expected print and increased risk aversion may see the yen rally.

British Pound Could Rally As UK CPI May Be Set To Hit 26-Year High

The British pound plummeted over the course of the week as mixed UK economic data could do little to help the currency fight a significant rally in the US dollar. UK producer prices rose 1.6 percent in April, the biggest gain since record-keeping began in 1986, underpinning the Bank of England’s inflation concerns. The sharp rise drove the annualized level up to 8.9 percent, marking the ninth consecutive months that prices have accelerated. All ten categories saw prices increase on the year led by a 28.5 percent surge in petroleum products on the back of record oil prices, which surged as high as $139 per barrel last week. Meanwhile, UK jobless claimed rose more than expected by 9K as firms cut workers amidst weaker growth prospects. Financial service companies lead the job losses, highlighting the lingering effects of the credit crunch. Furthermore, deteriorating labor market conditions have begun to depress wages as April’s growth in average earnings slowed to 3.8 percent from 4.0 percent in March. Overall, it is starting to become clear that the downside risks for the UK economy loom large, but with price pressures building rapidly, the Bank of England has no room to cut rates.

In fact, this week an expected rise in the UK consumer price index above 3.0 percent will force Bank of England Governor Mervyn King to write a letter to Chancellor of the Exchequer Alistair Darling explaining how he plans to bring CPI back to their 2.0 percent Indeed, UK CPI is anticipated to rise to an annual pace of 3.2 percent – matching a 26-year high – from 3.0 percent. The BOE cut rates as recently as April 10 by a quarter point to 5.00 percent, but the Monetary Policy Committee now holds a resoundingly hawkish bias. As a result, very strong UK CPI figures could lead the British pound to rally upon release, especially ahead of the release of the BOE June meeting minutes on Wednesday. The minutes are likely to reflect much of the same hawkish sentiment seen in the meeting minutes from May when most members said a rate cut would “make it more difficult to keep inflation expectations in line with the target,” and while “economic activity was likely to slow…some slowing in the growth rate of output was likely to be necessary for inflation to settle close to the target around two years ahead.” Furthermore, the MPC cited concerns that the public would get the impression that a rate cut was an effort to “stabilize output growth rather than maintaining its focus on the inflation target.” On the other hand, the minutes are also likely to show one vote for a rate cut by über-dove David Blanchflower, but if the vote count actually shows that the decision to leave rates steady was a unanimous one, or if there were any votes for a rate increase, the British pound could surge on the news.

Will A Surprise SNB Hike Keep The Swiss Franc From A Breakdown?

The Swiss franc was looking at a relatively quiet economic calendar last week, but the currency was nonetheless brought to the edge of a technical cliff as a strong US dollar countered fading risk sentiment for USD/CHF. In fact, opening this week, the major pair stands just off a very easily recognizable triple top at 1.0525 with the medium-term trend clearly favoring the upside. This resistance was made a threat after a three percent-plus rally last week that would ultimately resist the only economic data scheduled for the week. The Swiss employment data was more less anticipated with the seasonally adjusted rate holding steady at a five-year low 2.4 percent through the month of May – even as the economy reportedly slowed. Switzerland’s economy cooled decelerated to its weakest pace of growth in three-and-a-half years in the first quarter. More disturbing is the fact that major trade partners the US and Euro-Zone have seen consumer spending cool in more recent data which threatens to curb orders and therefore the need for human capital going forward. This is likely the fundamental group’s overwhelming surprise considering the franc hardly reacted to the news.

A far more prominent concern for Swissie traders last week - and no doubt going forward - was the ebb and flow of risk trends and unfavorable rate expectations. Risk proxies were put into a steep decent last week as fragile, global growth trends were put into jeopardy with policy makers hinting at raising rates despite what could be just the beginning of a broader cooling in economic activity. These rate expectations further raised the appeal of shorting the carry currency. In fact, over the past week, speculation of a FOMC rate hike has hit a fever pitch, market participants see the BoE moving on high inflation trends and the ECB has virtually guaranteed a rate hike next month. But, where is the SNB in this interest rate outlook.

We will see whether the Swiss National Bank is willing to keep pace with the hawkish crowd this week with the policy group scheduled to vote on interest rates Thursday. Nine out of 25 economists surveyed by Bloomberg expect Jean-Pierre Roth and his colleagues to vote a quarter point hike to 3.00 percent. This means, a firming of rates would be a considerable surprise and would in effect lead the hawkish leanings from Trichet, Bernanke or King. On the other hand, since they typically only meet once a quarter, a hold could put them well behind the trend in the interim and lead to significant selling pressure as carry considerations rebound. In addition to the rate decision, there are a number of indicators scheduled for release. The greatest chance for a considerable event-driven reaction from the market likely rest with the retail sales report scheduled for release on Monday and the first quarter industrial production gauge due Tuesday. Both are expected to deteriorate, which would no doubt severely limit growth projections. Other, lesser market movers crossing the wires are the ZEW sentiment survey, trade balance, money supply report and the upstream inflation figure.

Canadian Dollar Saved By Surprise BoC Hold, Can CPI Follow Through?

The Canadian dollar was riding high fundamental waves this past week and looks to do so again this week. However, despite receiving some of the currency’s top market movers this past week – and dramatic volatility – USD/CAD ended the session within the bounds of its wide 1.0350 – 0.97 range once again. On the other hand, while the pair has held below substantial resistance, pressure has clearly built up for a potential breakout. Crude oil has eased off its record highs, the outlook for monetary policy and economic conditions is beginning to favor the still undervalued US, and the retail speculative trader is betting heavily on maintained range conditions. This past week, the FXCM Speculative Sentiment Indicator reported the highest concentration of short USD/CAD positions in 18 months as retail traders believed they were looking at an easy range trade. However, retail traders are often on the wrong side of the market due to their inexperience and a trading style that is more akin to gambling, which makes this past week’s SSI reading a particularly strong contrarian call for a breakout.

Aside, from the whims of the speculative sector, fundamentals were certainly a strong driver for the Canadian currency this past week. Topping the headlines was the Bank of Canada’s rate decision, which likely saved USD/CAD from an upside breakout on Tuesday. There was a significant consensus for a 25 basis point rate hike to decelerate from the previous meetings’ half point cuts and to further prop the Canadian economy while inflation was below target. What the policy group did instead was to hold rates at 3.00 percent and adopt a stance interestingly resembles that of the Fed and ECB. The statement that accompanied the decision called current policy “appropriately accommodative,” while further stressing a focus on inflation – though their own projections have called for core inflation to stay under 2 percent through 2009. The rest of the week’s numbers were far reduced market movers. Housing was a point of contention as a modest upside surprise in construction on new residences was offset by the weakest pace of new home inflation in nine years. What’s more, the trade balance unexpectedly contracted to C$5.1 billion and capacity utilization fell to its lowest level in 15-years – all signs of slowing growth.

For the days ahead, economic event risk could once again bring USD/CAD to the brink of a breakout. The investment transactions, leading indicators and money supply data will all be second tier data. More pressing will be Thursday’s CPI release. After the BoC left rates unchanged, the highly speculative currency market will be looking for reasons to interpret the neutral changes as a first step towards rate hikes. As it stands, headline inflation is expected to step up to 1.9 percent and core to stay steady at 1.5 percent. This broader reading holds more potential though as the central bank suggested inflation could rise above 3 percent if energy prices persisted. The more promising market mover is the retail sales report. While growth has taken a back seat to inflation trends for monetary policy makers, the market nonetheless consistently responds with volatility to the easily interpreted reading.

Australian Dollar Gives Up Rally As Employment Disappoints

The proverbial chickens came home to roost last week for the Australian dollar as the developing slowdown in the domestic economy finally took toll on the buoyant currency. The first major blow came on Wednesday as June’s Westpac Consumer Confidence contracted sharply to print at -5.7% versus May’s 2.7% result. The reading marked the lowest level in nearly 16 years as consumers wavered in the face of rising food and energy prices. Meanwhile, the RBA has effectively ruled out monetary easing, choosing to err on the hawkish side of things as inflation is seen to exceed the target 3% level. The knock-out punch arrived on Thursday with May’s employment data. Economists expecting the economy to add 13.5k jobs were sorely disappointed as Australia shed -19.7k instead. The release ended a record 18 months of steady job growth and marked the biggest monthly decline since September 2005. Unable to hold up under the weight of deteriorating data any further, the Australian dollar collapsed from record levels to break through an upward-sloping support line that has guided the bullish trend since August.

This week’s calendar is notably uneventful, with the minutes from the last RBA monetary policy meeting the sole market-moving item on the docket. Few surprises are likely here as the RBA is firmly on hold at 7.25% with an upward bias should inflationary pressures not abate as forecast. With the domestic economy headed clearly south, the bank’s preferred scenario is taking shape and further rate hikes surely unnecessary in the near term. April’s Westpac Leading Index will somewhat defeat metric’s purpose as it is now far too backward-looking to offer substantial insight following last week’s dismal May and June releases. The same will be true of the Quarterly Wage Agreements report for the first quarter – the markets are already discounting a deteriorating labor market in the second quarter, so the strength in the first three months of the year will hardly matter. Australian dollar price action is likely to be dominated by the technical outlook, extending lower to test support near the 0.9200 level.

New Zealand Dollar Likely To Fall Further On Interest Rate Outlook

The New Zealand Dollar fell sharply for the second consecutive week of trade, as bearish momentum and worsening interest rate differentials doomed it to fresh five-month lows against its US namesake. Ostensibly strong economic data did little to change the currency’s fate; a surprising jump in the typically market-moving Retail Sales report effectively left the currency flat in the brief moments following its release. Traders initially sent the kiwi sharply higher on a 1.0 percent surge in Retail trade, but a closer look at the underlying report showed that core spending—excluding gasoline and auto purchases—actually fell a disappointing 0.5 percent through the same period. Fundamental outlook for the New Zealand consumer and overall growth effectively remained unchanged through the release, and the domestic currency responded in kind.

The term structure of NZD money market yields shows overwhelming market consensus that the Reserve Bank of New Zealand will be one of the few G10 central banks to cut interest rates aggressively through 2009. Given that the New Zealand dollar previously depended on sizeable rate advantages to forge multi-year highs against major forex counterparts, the recent reversal in trends suggests that we may see further NZD declines through the medium term. Continued turmoil in global financial markets only compounds the Kiwi’s woes, and momentum clearly remains to the downside for the Asia Pacific currency.

Short-term outlook for the NZD will likely depend on price action out of global commodity markets and risky asset classes, as an effectively empty economic calendar leaves it to the whims of broader market flows. It may be especially important to world commodity prices through for two reasons: first, New Zealand dollar has historically held a tight relationship to agricultural commodity prices. Second, the US dollar itself has become quite clearly correlated to developments in key raw materials prices. Any significant shifts in sentiment in commodities would almost definitely force a shift in the NZD/USD, while traders will otherwise bank off of price action in the US Dow Jones Industrial Average and other barometers of market risk appetite.

Boris Schlossberg is a Senior Currency Strategist at FXCM.