US Dollar Rally Could Falter If Fed Fails To Maintain Hawkish Bias

The US dollar has rallied significantly from its mid-July lows as consistently hawkish commentary by Federal Reserve officials has led traders to speculate over the central bank’s next move. As of Friday’s close, fed fund futures were only pricing in a mild 6.9 percent chance of a 25bp rate increase this coming Tuesday, as the markets are widely expecting the FOMC to leave rates steady at 2.00 percent. While CPI remains uncomfortably high, the US economy is still facing a major slowdown, as evidenced by the collapse of the housing sector and marked deterioration in the labor markets. However, this doesn’t mean that the US dollar can’t gain further. In fact, overnight index swaps are pricing in a whopping 75bps worth of rate hikes over the course of the next year, and if the FOMC’s policy statement focuses on “upside risks to inflation” rather than the economic slowdown and instability in the financial markets, traders will continue to bet on aggressive increases to the fed funds rate over the course of the next year. However this doesn't mean that the US Dollar can't go further. Ultimately, the fate of the dollar this week will depend far more on what the FOMC says, rather than what it does.

Other economic releases this week are likely to disappoint amidst weakening indicators that reflect American consumption habits. On Monday, personal income is forecasted to contract 0.2 percent, while personal spending growth may slow to a 0.5 percent pace. On Tuesday – well before the 14:15 EDT FOMC announcement – ISM non-manufacturing sector is estimated to fall to 48.0 from 48.2, signaling a contraction in business activity for the second consecutive month. This would be particularly dismal news for the US economy, as the non-manufacturing sector accounts for approximately 70 percent of total economic activity in the country and includes retail, services, and finance. Nevertheless, the reaction of the US dollar on the release of these indicators may only look like a blip on the radar, as the FOMC’s policy statement will have the greatest bearing on where the currency goes next.

Euro May Need A Hawkish ECB To Sustain Its Bullish Trend

The euro may be approaching a major turning point in its long-term, one-way trend. Against the Japanese yen and British pound, the currency has steadily pulled back to long-term support. Looking out to the week ahead though, the EUR/USD will likely be the defining pair for determining the euro’s long-term direction – and the outlook is precarious to say the least. Currently testing a year-long rising trendline, the currency’s true line in the sand will be 1.53; however, it will take more than a few second-tier economic indicators to force a breakout. Those looking for volatility should rest assured though, there is plenty of high level event risk to finally break a trend that has been guiding the euro higher for much of this decade (or offer a fundamental catalyst for a bounce off support to new record highs).

Looking at the listings on the euro’s docket, there will be a slow build into the climax of the week – the ECB’s rate decision. Wading through the first half of the week, fundamental traders will take in the last bits of growth and inflation-related data from which last minute adjustments to rate forecasts will be made. The Sentix Investor Confidence, Euro Zone factory-level inflation and retail sales reports will cross the wires Monday and Tuesday. The true driver however will be Thursday’s rate decision. While ECB President Trichet and his fellow board members are expected to leave the benchmark lending rate at 4.25 percent, there will nevertheless be considerable heat coming off this event. Following a quarter point hike last month (the bank’s first in over a year), policy makers will need to feed speculation that another hike is a possibility further down the road; or the euro will look increasingly overvalued against a currency that is expected to see 75 bps of tightening of its own over the coming year. In fact, just last week, the outlook for ECB rates measured through overnight interest rate swaps slipped into negative territory for the first time in years. Should Trichet’s commentary lean towards the dovish, the Euro may finally see a true correction.

A USD/JPY Breakout Is Only A Matter Of Time

Another week has passed with USD/JPY obeying major resistance read at 108.50. This level has stood since January, but time is no doubt limited for calm markets as technicals and constant fundamental pressure will eventually come to a head. Indeed, USD/JPY has maintained its bullish footing through past weeks, but this has largely been due to dollar strength and not yen weakness. In fact, outside of the the dollar-denominated yen cross, most of the Japanese currency’s other major pairings have actually pulled back to significant support levels in reverence for fading carry trade strength. Concern over risk potentially is certainly overshadowing the most expectation for returns on contracting interest rate differentials. Just last week, the market was reminded that liquidity is still a prominent concern for the financial markets - as the Fed’s most recent overbid $75 billion TAF auction and Merrill Lynch’s plans to sell dump $30.6 billion in bonds for a fifth of face value so poignantly reminded us. For the week ahead, the consistent buzzing of fear will remain; and it will be up to interest rate speculation to overcome the threat. In this respect, the Fed rate decision will be key to whether USD/JPY can push through 108.50 and have enough momentum to confirm the dominate trend change. No change is predicted; but in these markets commentary can be just as market moving given the right key words.

Aside from the unquantifiable event risk in the carry’s trade’s influence over USD/JPY, fundamental traders will also get a decent round of scheduled data to work with. From the Japanese calendar, the preliminary June reading of the Leading Index will offer a gauge for speculation on economic activity in the coming three to six months – and the consensus isn’t promising. More specific to the business and consumer side of the market, the well-regarded Eco Watchers sentiment is due towards the end of the week. Considering the feeble readings from employment, wages and spending, this indicator will struggle to offer a substantial rebound. From the other side of the pair, the ISM service sector activity report will be completely drowned out by the Fed decision (as will the entire week, even though the data is due early in the week).

British Pound Drops To Multi-Week Lows On Dismal Data

Our fundamental outlook for the British Pound took a clear turn for the worse through the past week of economic data, as key disappointments in CBI data, Nationwide House Prices, GfK Consumer Confidence, and PMI Manufacturing numbers all dimmed prospects for the UK economy. The Pound couldn’t seem to catch a break on a steady stream of bearish news, and the GBP/USD now trades at three-week lows. Whether or not the Sterling can indeed see a reversal of fortunes may depend on a key string of economic reports through the week ahead.

A Bank of England interest rate announcement headlines a week of noteworthy event risk for the British Pound, and the outcome of said announcement could very well force major moves in GBP pairs. According to a poll by Bloomberg News, 60 of 60 analysts polled believe that the BoE will leave interest rates flat at 5.00 percent through Thursday’s announcement. Yet interest rate markets show a 22 percent probability of a quarter-percentage point rate hike—hardly likely, but such uncertainty typically makes for volatility regardless of the outcome. Unfortunately for markets, the Bank of England does not usually release commentary following an unchanged rate decision, and stable rates will give little indication as to the future of UK yields. Watch for any surprises—especially as the British Pound is almost guaranteed to rally on a surprise rate increase from the central bank.

Swiss Franc Could Weaken Further As Manufacturing Activity Slows

Like the other major low-yielder – the Japanese yen – price action in the Swiss franc hasn’t had much to do with Swiss fundamentals. In fact, it has lately just served as an anti-dollar vehicle, much like the Euro. However, it is also worth keeping in mind that the Swiss National Bank takes a far more leisurely path to shifting monetary policy, since they only meet once every quarter. Furthermore, the SNB has not changed rates since the start of Q3 2007, and with indications emerging that the Swiss economy may be slowing, there is little chance that the conservative central bank will pull an aggressive move like ECB President Trichet and hike rates. As a result, from an interest rate perspective, downside risks for the Swiss franc persist.

Downside risks may persist from a fundamental perspective as well, though significant weight shouldn’t be thrown behind the release of this week’s indicators. First, SVME PMI is anticipated to slump to a nearly 3-year low of 53.6 from 54.9, which would reflect a deterioration of conditions in the Swiss manufacturing sector. Since the Swiss economy is highly dependent on exports of manufactured goods, this indicator may serve as a good bellwether of trade activity in coming months. Meanwhile, the Swiss unemployment rate is forecasted to hold at a 6-year low of 2.3 percent in the month of July, supporting the notion that consumption in the nation is holding up despite rising prices and more stringent credit conditions.

Will A Strong Labor Report Bring Back Loonie Bulls?

The Canadian economy has begun to contract as anticipated due to the headwinds from the U.S. downturn. A commodity boom spurred growth in the natural resource abundant regions, but manufacturing dependent areas have continued to slow as demand from the U.S. declines. The upcoming Ivey PMI is expected to show business investment falling after last month’s rebound, which was based mostly on increasing inventories. Considering that retail sales slowed in May, there could be a significant decline in that component which could weigh the indicator lower, adding to the bearish sentiment. Expectations are that the labor market will rebound from the 5,000 jobs it lost in June with a gain of 10,000. However, a consecutive month of job losses could send the loonie lower against the dollar, as the labor market has supported domestic consumption.

The com dollar currencies have all been under heavy selling pressure as oil prices continue to ease, and weakening fundamentals could lead to further loses. The USD/CAD reached as high as 1.0300-the highest since April 1st, before running into resistance. A break above 1.0381 could see the pair soar to test the 1.0500 handle. Yet, Canada unlike the other com dollar nations has employed an easing policy for the majority of the year, which could lead to a quicker recovery. Also, oil prices are poised to rebound as they reach technically significant levels. The pair is also trading near the top of its current channel which could lead to a retracement before it looks to go higher.

Is The RBA Getting Closer To A Rate Cut?

The Reserve Bank of Australia takes center stage this week as Glenn Stevens and company announce monetary policy on Tuesday. Expectations calling for rates to remain at 7.25% will likely be validated: Stevens made clear at the bank’s last meeting that he did not anticipate changing borrowing costs this year as the economy continues to grapple with inflationary pressure. That said, recent evidence suggests that a rate cut may come sooner than was otherwise expected. Last week’s surprising drop in TD Securities inflation may have been the first in a series of data reflecting the selloff in crude. Should this trajectory continue, the RBA may be faster to change gears to focus on economic growth. To that effect, traders will pay particular attention to the language accompanying Tuesday’s announcement as the market tries to gauge if rate cuts are to come this year.

July employment figures are also due, with expectations calling for the economy to add 5k jobs in July. The metric overshot expectations threefold in June as mining companies expanded capacity to meet Chinese demand for coal and iron ore. More of the same could be in store this time around: Australian exporters recently negotiated hefty contract price increases with their Chinese buyers, with analysts calling for revenues to increase between A$45 billion to A$55 billion this year alone.

Data Unlikely To Offer Relief As Kiwi Continues Lower

This week’s data is unlikely to offer much support for the beleaguered Kiwi dollar. Tuesday will likely see some mild contraction in July’s ANZ Commodity Price Index. Last month’s produced a flat result as higher beef and aluminum prices were offset by falling dairy. Dairy products continued lower for much of July but rebounded in recent weeks to largely the same levels as were seen at the beginning of the month. Beef prices added another 3.6%, but aluminum registered a sharp decline of nearly -12%. Lumber, another key commodity, lost 2.7%.

Second quarter jobs data is likely to disappoint again as New Zealand sinks deeper into economic slowdown. The prospect of accelerated monetary easing failed to boost Business Confidence in July as the metric fell for the first time in four months on entrenched expectations that rising living costs (oil, food) will crimp global demand. To that effect, employment conditions are likely to deteriorate further as firms tighten their belts to weather the downturn.

Boris Schlossberg is a Senior Currency Strategist at FXCM.