Dollar’s Fate in Fed’s Hands

Midway through this week we wrote, “Another night of back and forth price action as EURUSD continued to swing on either side of the 1.5500 figure which has become the literal and figurative level of equilibrium in the pair. The directionless price action is a reflection of the general confusion in the currency market as traders try to ascertain the true intentions of President Trichet and Chairman Bernanke.”

This week the game should become much more interesting as the FOMC rate announcement takes place on Wednesday and currency traders will get a much better idea if Chairman Bernake is serious about raising rates or is merely bluffing. While no one expects a hike this week, a hawkish tone in the post announcement communiqué would signal that a rate increase is coming as soon as September which in turn should prove dollar bullish or at very least supportive to the greenback.

With EZ rates seemingly assured to rise at least another 25bp as hawkish rhetoric from the region continues to signal further tightening, the pressure on the Fed to make good on their promise has increased markedly. If the FOMC statement maintains a neutral tone the buck is likely to see more stress next week with 1.5800 level coming into view. The one possible reprieve for the dollar could come from the oil market. If crude prices weaken materially dropping below $130.00 inflation expectations may ease, eliminating some of the urgency for a rate hike. At this point however even with the week-end announcement from Saudi Arabia that they will increase production by 2%, that scenario seems like a long shot and buck's best chance lie with a hawkish Fed.

Euro Likely to Face Weak Data, But Anti-Dollar Status May Matter More

The euro climbed steadily over the course of the week as stronger-than-expected inflation data increased speculation that the European Central Bank will indeed raise rates in July. In fact, the final reading of the Euro-zone Consumer Price Index for the month of May unexpectedly hit a fresh 16-year high of 3.7 percent. The data underpins ECB President Jean-Claude Trichet’s hawkish bias, as the bank’s primary mandate is to maintain price stability. Furthermore, approximately two weeks ago, Mr. Trichet said that some council members actually wanted to raise rates during the June policy meeting and also said during the Q&A session that there was a chance that the central bank would raise rates in July. This represented a major shift in sentiment, as the debate in the markets before the meeting centered more on when the ECB would eventually cut rates. However, now that the ECB has proof that inflation is accelerating rapidly, they may actually hike by 25bps next month to 4.25 percent.

While there is quite a bit of event risk on hand for the euro this week, none of it will be nearly as important for the EUR/USD pair as the US Federal Reserve meeting and rate decision on Wednesday. As a result, the euro may simply trade as the anti-dollar vehicle. Nevertheless, it will be worth watching Monday’s releases of the German IFO Survey and Euro-zone Services PMI at 4:00 EDT. Sentiment amongst German businesses is likely to turn more pessimistic in June, according to the IFO survey, and this release tends to be a significant market-mover for the EUR/USD pair on a very short-term basis. Given the surge in oil, broad indications of mounting inflation pressures, slowing in the Euro-zone's economies, and the European Central Bank's staunchly hawkish bias over the survey period, the IFO reading is likely to fall in line with - if not more than - expectations. Furthermore, we saw that last week's ZEW survey of German financial analysts slipped more than anticipated, weighing the risks for the IFO survey further to the downside. However, at the same time, the preliminary reading of the Euro-zone's purchasing managers index (PMI) for the services sector will be released. The index is expected to ease slightly lower to 50.5 from 50.6, but the key here will be to see if it is above or below 50, as the former will indicate expansion in the sector, while the latter will signal contraction. Euro-zone services PMI has barely managed to hold above 50 since the beginning of the year, suggesting that weakness in the sector will weigh on expansion as a whole throughout the region. Nevertheless, the German IFO survey will likely have the greatest impact on the European markets on Monday morning, unless PMI services misses forecasts by a wide margin. After Monday, though, EUR/USD trade will depend more on the US side of the coin.

Yen Finds Strength In Risk Aversion But Data May Intervene

After four week’s of steady declines, the Japanese yen finally found its way to an authentic advance against its major counterparts. However, the currency will need considerable momentum over the coming days if the market is to produce a true trend reversal considering all the former support levels that will now stand in as resistance. Looking at the fundamentals behind the first stage of the yen’s turn, there may be hope. There were two market dynamics working to unwind carry and therefore bring investors back to the Japanese unit. The first push was from the potentially passing influence of analysts warnings about growing complacent on the health of the markets. The recent improvement in credit markets was cast into doubt when a Goldman Sachs report suggested US banks would need to raise an additional $65 billion in capital to offset ongoing write downs; and John Paulson (manager of the Paulson and Co. hedge fund that positioned itself for the subprime meltdown) forecasted total write downs would eventually total $1.3 trillion. Holding a more lasting influence over the markets though has been the shift in interest rate expectations for yield differentials. On the low end of the yield spectrum, while the BoJ is expected to hold steady, the Fed (the dollar being a funding currency given its low 2.00 percent benchmark yield) has ramped up rhetoric in warning of possible near-term rate hikes. At the same time, the customary carry currencies have stalled on their own rates. The RBNZ has said it would cut rates over the coming year, RBA rhetoric has put hold a neutral stance for the remainder of 2008, and even the BoE has suggested it was against raising rates even though their own inflation forecasts see 4.00 percent in the second half.

And, though it didn’t have an immediate impact on the yen, this past week’s economic calendar nonetheless offered a number of indicators that have reshaped the outlook for growth. On Monday, the Cabinet office issued their monthly economic report for June in which the group finally admitted to see signs of weakness after months of ‘pausing’ and even improvement back in February. Acting as confirmation of the government’s read on activity, the All Industry Activity indicator for April showed mixed results. The sharpest improvement in 14 months was due solely to a four-year high in tertiary (expected to be temporary). This number masked significant declines in manufacturing, construction and government spending.

In the days ahead, interest rate considerations for the carry trade will no doubt remain a major influence on price action; but data will also play a bigger role. The FOMC rate decision is expected on Wednesday; and the market has very hawkish expectations for the second lowest yielder in the liquid market. If there is rhetoric to confirm a hike by September, it could significantly change the carry trade dynamic. Aside from the rate decision, the economic calendar will be fully stocked. Top event risk is early Monday’s BSI sentiment report for the second quarter. Then, the end of the week will see spending, employment, retail sales and inflation figures all within a 20 minute period.

Pound Advances As BoE Running Out Of Alternatives To A Rate Hike

Inflation in the U.K. rose to 3.3% in May from 3.0% the month prior. It was the highest level since at least 1997 when records began. BoE Governor King was required to write a letter of explanation to Chancellor Darling as to why prices have surpassed the 2% target by more than 1% and what course of action will be undertaken- the only previous letter was written in April 1997. In his letter he wrote that he expects that inflation will rise above the 4% mark and that the path for interest rates was uncertain, as they try and balance the goal of reaching the 2% target with slowing growth. The comments sent the pound reeling until the minutes from the central bank policy meeting and retail sales inspired a sterling bull rally leaving the pair higher for the week.

The Bank of England voted 8-1 to keep rates on hold at 5.00% during its last monetary policy meeting. Perennial dove David Blanchflower was the only member to call for a rate cut, stating that the growing risk of slowing growth outweighed inflation risks. However, the majority saw no case for a rate cut, due to the risk of rising wage demands as a secondary effect of increasing prices. Cable bulls came out when U.K. May retail sales significantly surprised to the upside printing a 3.5% jump against expectations of a 0.1% decline, which was the biggest increase since records began in 1986. The rebound ended consecutive monthly declines of 0.3% in April and March. A 9.2% increase in clothing sales from a 2.1% decline in April, as Britons continued their penchant for shopping. The warmest May ever saw shoppers load up on seasonal foods and clothing lifting annualized sales 8.1% from 3.8% the month prior. The news will allow the BoE to keep interest rates on hold as they continue to monitor the upside risks of inflation. Central Bank governor Mervyn King warned in a speech at the Mansion House that wages will stagnate and the rising energy costs will squeeze consumers. He also asked Britons not to panic and demand higher wages as the period will be short lived. The comments were due to the Shell Tanker union negotiating a wage increase of 14% over the next two years, evoking fears that it will provoke other labor unions to call for similar hikes, as wage inflation will intensify the BoE’s battle.

This week’s calendar won’t have the potential volatility as last week, but an end of the week GDP print could bring out bear bulls if it shows negative growth. Greater than expected growth will generate bullish sterling sentiment, especially with the expected improvement in the CBI’s distributive trade report. Also, a rebound in house prices may signal a housing bottom, which would be welcomed news to the central bank.

Swiss National Bank Removes Key Pillar of CHF Support

The Swiss Franc lost a key pillar of support and fell sharply against major forex counterparts to end the week’s trade, as a disappointing Swiss National Bank interest rate decision reduced hopes of higher domestic interest rates through 2008. The SNB surprised many by leaving its short-term rate target flat at 2.75 percent, and relatively dovish commentary nixed expectations that rising headline CPI would be justification for higher interest rates. The low-yielding Swiss Franc instantly fell on the news, and its previous rallies on robust rate expectations were suddenly called into question. A cursory look at the term structure of money market yields shows that markets still expect the SNB to increase interest rates through the longer term, but dovish short-term expectations could nonetheless doom the Swissie to further declines against higher-yielding counterparts. According to SNB President Jean-Pierre Roth, the central bank feels it can afford to leave rates unchanged despite steady rises in headline CPI inflation. His post-announcement text specifically states that the SNB believes short-term price gains to be transitory in nature—decreasing the need for a monetary policy response. There are considerable risks to the SNB’s inflation outlook, but official rhetoric suggests that domestic yields may remain unchanged through the foreseeable future.

Already we see signs that the progressively higher-yielding euro may regain upward momentum against the Swiss Franc. The EURCHF has established fairly clear technical support just above the 1.6000 mark, as bears have thus far been unable to push the currency through said level. The true litmus test may come on a challenge of trendline and moving average resistance at the 1.6300 mark, however, with a significant year-to-date top at 1.6379 not far behind. Whether or not the Swissie will continue to weaken against the euro and other currencies will likely depend on fundamental developments in other major economies; a relatively empty Swiss economic calendar is unlikely to bring major volatility to CHF pairs.

Only clear surprises out of upcoming data would force noteworthy moves in the domestic currency, and as such CHF traders should take their cue from developments in other key economies. Arguably the most important event out of any economy in the week ahead, the US Federal Open Market Committee (FOMC) will announce its short-term interest rate target on the afternoon of the 25th. Given international equity markets’ sensitivity to FOMC developments, any surprises out of said announcement will likely bring sharp volatility to global risky asset classes. The Swiss Franc continues to be a safe-haven currency of sorts, and a sharp selloff in the Dow Jones Industrial Average or other major index would likely force a CHF rally. Otherwise, Swissie traders should watch for any surprises out of the sporadically market-moving KOF Swiss Leading Indicator report due Friday.

Canadian Dollar Buoyed by CPI, Can it Sustain Upward Momentum?

The Canadian Dollar rallied against its US namesake for the first week in five, as strong surprises in Canadian Consumer Price Index and Retail Sales reports improved fundamental outlook for the domestic currency. Headline CPI growth of 1.0 percent in May, its highest monthly gain in over 17 years, instantly fueled a rally in domestic yields and the Canadian dollar responded in kind. The Bank of Canada’s preferred Core CPI measure grew a much more moderate 0.3 percent through the same period, but the frightening headline number easily solidified forecasts that the central bank would leave interest rates unchanged through the foreseeable future. Positive momentum continued into the following day’s Retail Sales report, and a stronger-than-expected Retail Sales print should have provided a further boost to the previously beleaguered Canadian currency. Yet a seemingly inexplicable surge in bids for the USDCAD led to a dramatic sell-off in the Canadian dollar, and the unexpected rally forced many traders to liquidate their USDCAD short positions—further fueling the advance. The Loonie finished flat through Friday’s trade, but short-term momentum leaves USDCAD risks to the downside through near term price action.

An effectively empty Canadian economic calendar means that the USDCAD will likely trade off of developments in the US economy, and a highly-anticipated Federal Open Market Committee (FOMC) interest rate announcement is almost guaranteed to drive significant volatility in the North American currency pair. Markets widely expect that the US FOMC will leave its key Fed Funds rate unchanged at 2.00 percent through its Wednesday announcement, but subsequent commentary is almost certain to make for sharp price moves across a broad range of relevant asset classes. A vocal minority has priced in an approximate 10 percent chance that the Fed will raise rates by 25 basis points to 2.25 percent, and such a move would force a substantial USDCAD advance. Otherwise, traders will try their best to decipher the direction of US interest rates—especially as the Bank of Canada has signaled it will likely leave rates unchanged through the medium term. If the FOMC hints that it is willing to raise rates in the face of mounting price pressures, then we could likewise see a sizeable US dollar rebound. More dovish talk favors the Canadian dollar, while effectively neutral statements leaves the US Federal Reserve in roughly the same position as the Bank of Canada. Given a stable outlook for US-Canada yield differentials, we could see the USDCAD continue to trade sideways through the foreseeable future.

AUD - Light Calendar Leaves the Australian Dollar at the Mercy of Bearish Technicals

The Australian docket has offered little by way of new insights since a trend-changing May employment report revealed the economy failed to add 13.5k jobs as expected to shed -19.7k instead. Tuesday saw the publication of the minutes from the RBA’s June meeting. Policymakers reinforced a familiar rhetoric, saying of their fight to tame inflation that “on current policy settings, the necessary moderation in demand is likely to occur.” Glenn Stevens and company appear comfortable with monetary policy working as intended and are likely to keep rates at 7.25% for the remainder of the year. The Westpac Leading Index showed slight improvement in April, printing at 0.4% versus 0.1% in March. The result suggests the economy will expand at an annualized 2.8% in the next three to nine months, a pace that is well below the long-term average of 4%. This is in line with the RBA’s best-case scenario as policy makers bank on slowing growth to help relieve upward pressure on the price level.

The coming week is equally light on significant data releases. Things get underway with May’s edition of the New Motor Vehicle Sales figure. Actual readings for the metric have underperformed expectations since September of last year and are likely to do so again this time around. Soaring crude oil prices have crimped demand for petrol and depressed automotive sales globally, and Australia far from an exception. Wednesday brings the Conference Board’s Leading Index for the month of April. The metric is a composite measuring the overall health of the Australian economy. A decline would amount to the fourth consecutive monthly loss. The March release was accompanied by a statement noting that “the leading index declined moderately through the first quarter of this year [and] a more moderate pace of economic growth is likely to continue in the near term.” May’s Job Vacancies numbers released the same day will surely prove dismal after the aforementioned Employment Change disappointment for the same period. In sum, this week’s data is likely to further support the RBA’s policy stance and thereby offer few substantial changes to current Australian dollar sentiment. Two weeks ago, the AUDUSD broke through a supporting trend line that guided price action higher since August 2007 to extend as low as 0.9326. The pair has since completed a technical retracement to re-test trend line support-turned-resistance and looks poised to resume downside momentum.

New Zealand Dollar Downtrend Could Accelerate On Q1 Data

Last week, traders were treated to a New Zealand calendar completely bare of any significant event risk. Manufacturing Activity dropped dramatically in the first quarter, printing at 3.7% versus 8.3% in the closing quarter of last year. May’s Performance of Services Index continued to signal contraction for the second consecutive month with a reading at 49.1 (a value above 50 signals expansion). Visitor arrivals recovered a bit in May, expanding 9.4% following an -11.8% drop in April. None of these releases generated any attention from the markets as NZDUSD traded along an established technical trajectory. Price action has been defined by a downward-sloping channel since mid-March. The latest oscillation saw the pair hit this channel’s bottom at 0.7500 last week following a surprising dovish turn by the RBNZ as Governor Alan Bollard predicted rate cuts by year’s end. With nothing on the calendar to alter the underlying fundamental picture, NZDUSD embarked on an orderly retracement higher within the channel’s boundaries.

While the lull continues into the first half of this week, the calendar heats up on Wednesday with the Current Account Balance release for the first quarter. Estimates see the deficit contracting sharply from –NZ$3.41 to –NZ$1.67 billion as rapidly falling consumer confidence likely suppressed demand for imported goods. On balance, a decline in dairy prices in the first quarter will surely deflate export volume readings. Dairy products account for one-fifth of all New Zealand exports. Thursday follows up with the first quarter’s overall Gross Domestic Product reading. Expectations are for GDP to turn negative for the first time since the end of 2005 to print at -0.3% versus a rise of 1% in fourth quarter of last year. The forecast is reinforced by ANZ, the nation’s largest lender, whose leading index showed economic activity declined -0.6% from end of last year. May’s Trade Balance will hit the tape alongside the GDP release, with expectations favoring a surplus of NZ$150 million as imports fall along with overall consumption. All told, the GDP release is likely to dominate the market’s attention, as the magnitude of a decline will be used to forecast the timing of a RBNZ rate cut. Should ANZ’s dire estimate be validated, the NZDUSD decline is likely to accelerate downward past the 0.7500 level. Should this materialize, the pair has scope to collapse as low as 0.7180.

Boris Schlossberg is a Senior Currency Strategist at FXCM.