Will The Dollar Buckle?

Forget microeconomics. The currency market these days is trading almost exclusively on two macro themes. One - are Fannie and Freddie about to cause a systemic collapse of the US financial system? Two – is Iran really trying to provoke a military response from Israel? If the answer to either one of those questions is yes, the dollar may buckle under pressure.

In the first case, a bankruptcy of the two GSE giants which between them guarantee more than 5 Trillion dollars of mortgage assets could create a massive disruption in the financial system sending capital towards the euro as a safe haven bid. In the second case, escalation of geopolitical tensions is likely to only expand the fear premium in crude as worries about disruptions in the strait of Hirmuz will keep oil traders in a state of anxiety and push prices above the $150 level. In that outcome, skyrocketing inflation will also favor the euro as the ECB appears to be far more serious about controlling price pressures than the Fed.

Fortunately, as the week came to a close neither one of the doomsday scenarios occurred. Fannie and Freddie managed to live another day and the fixed income markets narrowed the spread premium of their bonds over Treasuries as authorities worked all day to reassure the markets. If the dust settles next week and investor confidence returns, the dollar could see a rebound, especially against the yen as risk premiums abate. If however we see a second round of panic selling and the Dow continues to drop towards the 10K level, the dollar will likely weaken across the board with EURUSD pushing through the 1.60 figure as volatility spikes.

As to the micro story, inflation gauges will be the focus of the week with both PPI and CPI numbers due out mid-week. Given the merciless increases in energy costs, inflation reports are likely to surprise to the upside but just how much of an impact they will have on price remains to be seen. One other report that’s sure to interest the currency market will be the minutes of the last FOMC meeting which may help traders determine the seriousness of Fed intention to fight inflation and finally everyone will pay attention to the Retail Sales number to sense just how well the US consumer is coping with this turmoil.

Euro: Trichet Remains Hawkish Despite Signs of Economic Stress

For the most part, the euro has been trading simply as an anti-dollar vehicle, as the greenback has plummeted across the majors. Indeed, solvency issues at Freddie Mac and Fannie Mae threaten to throw the US financial markets and economy into a downward spiral. However, conditions in the Euro-zone aren’t exactly rosy either. During the month of May, exports from Germany – the Euro-zone’s largest economy - fell by the most in almost four years at a rate of 3.2 percent. European exporters appear to be struggling with a nasty combination of the euro’s 15 percent appreciation against the dollar in the past year along with waning global demand. Furthermore, the region is getting squeezed by record high oil prices, which was responsible for the upward revision to Euro-zone imports in the first quarter that led GDP to be revised down to a 2.1 percent from 2.2 percent. Nevertheless, European Central Bank President Jean-Claude Trichet – who raised rates in June to 4.25 percent – remains hawkish as he said on Wednesday that inflation would remain above target for some time, that economic fundamentals were sound, and that upside risk remained because of high commodity prices. Indeed, as long as Trichet continues to sound off with such biased rhetoric, euro strength will be underpinned.

Looking ahead to this week, Euro-zone CPI figures for June are not expected to be revised from initial estimates of a 4.0 percent annual increase – a more than 16-year high – and such a result is unlikely to stoke volatility in the euro. However, if CPI is revised higher, the news would be extremely bullish for the euro, especially since Trichet remains hawkish. On the other hand, a downward revision could lead the euro to sell-off sharply. Meanwhile, investor sentiment in Germany and the Euro-zone’s trade balance are both anticipated to deteriorate further, adding additional downside risk to the currency. Nevertheless, if the Freddie Mac/Fannie Mae story continues to play out during the week without resolution, the euro’s status as an anti-dollar currency could be to the benefit of EUR/USD bulls.

USD/JPY May Finally Find Its Major Breakout As Market Fears Swell

This past week was a volatile one for risk trends and the principal carry trade – the USDJPY. Range conditions have reflected the uncertainty surrounding the future of the pair and the broader carry strategy; but the past few week’s worth of price action does not do the pressure in the market justice. Looking at price action over the longer term, however, the potential for a breakout is more clearly read. A broad wedge has been shaped by the steady rising trend channel from March hitting resistance seen in the trend of falling highs from last August. Essentially, this has left the market less than 200-points of room to maneuver – and these constraints on price action couldn’t come at better time for those traders waiting for volatility.

Over the past week, the economic docket was holding a few high-level indicators; but yen traders were clearly more concerned with the commotion in broader financial markets. This past week, capital markets the world over were tipping into official ‘bear market’ territory. In fact, the MSCI World Index closed Friday’s session 20 percent off its record highs set just this past October. However, it is debatable whether or not this is the evolution of a natural bear market or the next leg of a crippling credit crunch and financial market crisis. The former could keep the carry trade on the rise as investors scan the market for better sources of income. Alternatively, the latter scenario would result in violent volatility and another liquidity depression that would require banks and managers to raise capital (for which carry is a prime source) to fortify reserves. Recent data has been suggesting the markets are heading for the worst. In Europe, some derivative markets have disappeared, banks have had to pay record prices to raise capital just to meet capital requirements and the Bank of England issued a report saying credit conditions would be worsen in the third quarter. Far more concerning however was situation with Fannie Mae and Freddie Mac in the US. The ball began to roll when analysts suggested the two firms would need to raise nearly $75 billion between them to avoid default and lead to the collapse of nearly $5 trillion in loans (nearly 40 percent of all US residential loans). Policy officials tried to assure they would meet their capital requirements; but the fallout from the Bear Stearns meltdown is too fresh to allow calm heads.

Heading into this week, the barometer on broad financial risk will determine carry and the USDJPY’s direction. The currency market has done well to avoid the inevitable breakout until now; but with little room to maneuver and risk rising, traders are being backed into a corner. No doubt, the Freddie Mac and Fannie Mae story will be a dominate headline, but not the only one. In the second half of the week, the major banks will begin to release their second quarter earnings data. A number of banks have issued guidance on improved quarters and some even expecting profits. However, if write downs and credit losses meet another liquidity crisis, a rush of panic selling will no doubt follow and USDJPY could plunge. On the other hand, should the Fed’s offer to open the discount window to the US lenders soothe fears and the accounting figures show the worst is behind us, USDJPY could overtake 108.50 as the market satiates its renewed appetite yield.

BoE Leaves Rates Unchanged As Country Inches Towards Recession

The BoE left their benchmark interest rate unchanged at 5.00%, despite inflation breaching their 3% threshold. The central bank isn’t able to take price stability measures, as the country continues to inch towards a recession. The housing market remains in its biggest slump since the 1990’s with Halifax-the country’s biggest lender- reporting prices falling another 2% in June. In fact the U.K. telegraph has stated that based on the recent fall in prices that the contraction now rivals levels not seen since the Great Depression. Additionally, industrial production declined 0.8% in May bringing the annualized rate down 1.6% as it saw declines in every sector except chemicals. Despite a weaker pound exports haven’t increased, leading to May’s trade deficit widening more than economist had expected. Imports continue to rise as costs for fuel and food remain at elevated levels. U.K. producers aren’t expected to receive any support domestically, as the housing downturn and rising inflation led to consumer confidence falling to 63 from 65 the month prior. Despite the doom and glom emanating from the U.K. the GBPUSD would end the week higher as broad based dollar weakness on the back of the U.S. mortgage GSE’s potential takeover by the government.

The lack of a statement from Governor King following the BoE’s rate decision, has led to speculation that the central bank may leave rates unchanged for the remainder of the year. Inflation in the country is expected to remain above the 3% threshold for the next few quarters requiring Governor King to write more letters of explanation to the government. Yet, as long as the housing slump continues and the credit markets remain tight, the MPC’s hands will be tied. Banks continue to refuse to lend, sending mortgage rates to the highest in eight years. Thus, it has become clear to U.K. policy makers and their brethren from across the pond, that only time can further loosen credit markets, as they have exhausted their resources.

The upcoming economic calendar will provide significant event risk as employment and inflation data will cross the wires. Consumer prices are expected to have risen another 0.4% in June bringing the annualized rate to 3.6%. Yet, the unemployment rate is expected to rise to 2.6% as job losses may grow by another 10,000. The data will further amplify the central bank’s difficult position of weighing slowing growth versus rising inflation which may leave the pound exposed to the broader dollar sentiment. However, the pound is approaching significant resistance levels which may deter further appreciation.

Swiss Franc Rides Dow Rollercoaster As Credit Concerns Return

The Swiss Franc moved in tandem with the Dow Jones Industrial Average for most of the week as the week was filled with whipsaw price action on risk winds and oil prices. The volatility in stocks was triggered by Lehman Brother’s warning that Fannie Mae and Freddie Mac could be forced to raise as much as $75 billion in capital to offset write downs and meet new accounting rules. The announcement set up speculation that the mortgage lenders may be insolvent which sparked extreme risk aversion and sent the USDCHF tumbling. A $10 dollar drop in oil prices would see stocks and the dollar rally. The fall in crude was short lived as missile testing in Iran would lead to supply concerns and renew risk aversion which would provide Swiss Franc support. Hank Paulson tried to reassure investors Fannie Mae and Freddie Mac were "adequately capitalized" in the face of a "challenging period", when he testified before the House Committee on Financial Services. However, rumors that the government would be rescuing the mortgage lenders would sink the pair

The major event risk on the economic docket is the Swiss retail sales report. Economists are expecting a rebound of 3.8% in May from the month’s prior decline of 9.4%. The improvement in consumer consumption may not have that much influence on the pair since the SNB has already established that they have turned their focus away from inflation. Nevertheless, if domestic growth can remain strong, it will reduce the need for the central bank to take measures to promote growth. The following days ZEW survey is expected to show the outlook for the economy progressively getting worse. Ultimately, risk winds may have sway over the pair again, as the fallout from the potential insolvency and takeover of Fannie Mae and Freddie Mac may send investors seeking the safety of the Swiss Franc. However, if the rumors are all smoke and no fire then the USDCHF may reverse its recent losses.

Bank of Canada to Dictate Direction in Canadian Dollar

The Canadian dollar joined all G10 currencies in moving notably higher against the US dollar, but a key disappointment in domestic economic data meant that the Loonie saw a substantive pullback against key counterparts. A sharply worse than forecast labor report cast doubts on the strength of the Canadian economy, and foreign currency traders voiced their displeasure by sending the CAD sharply lower in its wake. A similarly pronounced US dollar selloff meant that the USDCAD remained flat through Friday trade, but this hid the fact that sentiment took a noticeable turn for the worse in the Canadian dollar. Two-year swap rates traded at their lowest levels in over a month, and many now believe that the Bank of Canada will feel at ease leaving interest rates unchanged through the medium term. The BoC showed previous concerns that unemployment near 30-year lows would allow for heightened wage pressure; the gravity-defying labor market showed little vulnerability to a broader domestic economic slowdown. Yet cracks are clearly starting to show in the labor market’s façade with employers shedding a worrisome 39,000 full-time jobs through the month of June following a 32,000 loss in May. It’s clear that two months don’t necessarily make a trend, but it is likewise difficult to ignore signs that conditions may continue to deteriorate through the medium term. Canadian fundamentals were otherwise positive on the week, but above-forecast International Merchandise Trade Balance and Housing Starts figures did little to counteract the gloom surrounding the labor market disappointment.

Market attention now turns to the coming week’s key Bank of Canada interest rate decision, and traders are likely to respond to any significant shifts in rhetoric from the Canadian central bank. A Bloomberg News survey shows that 19 of 20 analysts polled expect that the BoC will leave rates flat at 3.00 percent, but such clear consensus does not necessarily mean that stable rates would leave the Loonie unchanged. Traders previously predicted that the BoC would continue cutting interest rates in line with the US Federal Reserve, but a clear deterioration in Canadian Core CPI forced the bank to admit that inflation risks remained too high to ease monetary policy. It will be interesting to note, however, whether officials make any reference to recently bearish labor data and reassess dangers posed to domestic economic conditions. A cursory look at growth-linked and inflation data shows that the BoC will have a difficult time reconciling inflationary pressures and slowing expansion. As an inflation-targeting central bank, it will need to do everything in its power to keep price growth expectations contained. Yet it will be hard-pressed to ignore job losses, and the net outcome will be critical to outlook for the Canadian dollar. It may take a fairly significant shift in speech to break the Canadian dollar out of its multi-month range; barring a turn for the worse in the CAD or the USD, we are likely to see the USDCAD remain within a relatively tight medium term trading channel.

Conflicting Data Leaves Australian Dollar Searching For Direction

Australian dollar price action seesawed last week as conflicting economic data pushed AUDUSD in opposite directions. The first half of the week yielded bearish outlook. AiG’s Performance of Construction Index showed modest improvement, printing at 40.3 in June versus 36.9 in the previous month. That said, the index remained firmly below the 50 boom-bust level and continues to indicate contraction. June’s ANZ Job Advertisements continued to decline, falling an additional -3.0% following an easing of -1.7% in May. A dismal June Business Confidence report saw the headline figure print at the worst level since a spike low in September 2001. Consumer Confidence followed suit as Westpac’s index tumbled in July, reaching lows unseen since 1992 with a reading at -6.7% versus -5.6% in the preceding month. May’s Home Loans and Investment Lending statistics also took a beating, with the former registering a fall of -7.9% versus expectations of -2.0% while the latter dropped -6.8% versus 1.4% in the preceding month. Home Loans now stand at the lowest since 2000 with Australians unlikely to take on debt with borrowing costs at record levels.

Midweek, sentiment shifted radically as June’s Employment Change data surprised substantially to the upside, showing the economy added 29.8k jobs versus the expected 10k. The reading reversed last month’s loses, revised down to -25.6K. China’s insatiable appetite for Australia’s coal and iron ore exports has fueled a boom in the mining sector with employers rushing to expand capacity (both labor and otherwise) to meet demand. Having started the week at 0.9625 against the greenback, the Australian dollar reached as low as 0.9475 only to rebound back above the 0.96 mark.

This week begins with May’s Westpac Leading Index. April saw the index predict the economy was growing at an annualized growth rate of 2.8%, a reading substantially below trend levels at 4%. Most economic indicators returned decidedly negative in May, suggesting Westpac’s growth rate forecast will suffer further slowdown this time around. Wednesday’s preliminary estimate of June import levels will likely be inflated by higher oil and food costs to register a strong headline reading. The week will conclude with Import and Export price indices for the second quarter. The commodities rally is likely to play a strong role in driving both higher. Import prices will be buoyed by oil and food, while Export prices will benefit from appreciating coal and iron ore. On balance, this will offer little bullish momentum to the Australian dollar. The RBA is not scheduled to announce monetary policy again until September, and Governor Glenn Stevens made it quite clear at the last meeting that he saw economic growth declining substantially enough to trim inflationary pressure. All told, a rate hike is out of the question in the near term. Barring truly wild deviations from expectations in the data, this week will see the Australian dollar guided by established technical levels.

NZ Dollar to Remain Ranging as Data Fails To Surprise the Market

Last week’s bare data docket saw the New Zealand dollar oscillate sideways between familiar range boundaries. NZIER’s Business Opinion Survey was static at -64 in the second quarter, remaining at the lowest levels since 1986. The Business NZ Purchasing Manager Index carried the same theme further, showing business sentiment declined in June with a reading at 45.7 versus 47.9 in the preceding month. REINZ House Sales improved a bit, showing decline of -42.4% in the year to June versus -52.9% in the preceding month. While this sees the metric rise marginally higher from all-time lows, it still paints a picture of a housing market in broad decline as New Zealanders are discouraged from big-ticket purchases by a deteriorating economy and record-high borrowing costs. The release went by virtually unnoticed by the market. Although the implications of last week’s data do not bode well for the health of New Zealand’s economy, they are hardly shocking to traders that are already primed for the first RBNZ rate cuts since 1993 to be had this year. Indeed, the lack of surprises in economic data releases has kept NZDUSD in a well-defined 100-pip range since mid-June.

This week’s calendar could see New Zealand dollar price action become a bit more interesting. Monday morning brings May’s Retail Sales figure. Economists forecast the headline figure to descend into negative territory after April’s jump to 1%. Traders will pay particular attention to the core figure as they try to filter out distortions from booming oil prices to divine an accurate reading on domestic demand. This in turn will help to pinpoint when the RBNZ will step in to cut borrowing costs. The week ends early with a packed calendar on Tuesday. Hitting the tape first will be June’s Performance of Services Index and Food Prices data. These will likely prove uneventful: broadly declining business confidence suggests the former will fit with the overall theme of economic slowdown while the latter is sure to be skewed by buoyant global commodity markets. Traders will be paying far more attention to Consumer Prices for the second quarter. Expectations call for a near-doubling of the price growth rate since the first quarter, with annualized inflation registering at 3.8%. Any downside surprise here will put tremendous downward pressure on the Kiwi as it would give the RBNZ room to cut rates sooner rather than later. Alternatively, should the metric print in line or even higher than expected, traders will probably see little action in the Kiwi as the current picture will have remained largely the same.

Boris Schlossberg is a Senior Currency Strategist at FXCM.