US Dollar, Japanese Yen Fall as Risk Appetite Lifts Carry Trades, S&P 500

The US dollar and Japanese yen were the weakest of the majors on Monday, as buoyant risk appetite weighed on the low-yielding currencies but lifted carry trades and equities, with the S&P 500 ending the day up 3.39 percent. US economic news was surprisingly strong, as US data showed that construction spending rose 0.3 percent in March, thanks to increased private and public non-residential construction, while pending home sales rose for the second straight month in March at a rate of 3.2 percent. Furthermore, the Federal Reserve's April 2009 Senior Loan Officer Opinion Survey on Bank Lending Practices showed that, on net, the percentage of respondents that "reported having tightened their business lending policies over the previous three months" was down for the second consecutive month, but remains "very elevated." However, the report also noted that a "somewhat larger" percentage of domestic banks reported tighter residential mortgage lending conditions, suggesting that consumers aren't seeing much of a change in the credit markets.

Looking ahead to Tuesday, data due out at 10:00 ET is expected to show that conditions in US non-manufacturing sector - which accounts for approximately 70 percent of total economic activity in the country and includes retail, services, and finance - are anticipated to have improved somewhat in April as of the Institute for Supply Management’s (ISM) index is estimated to rise to 42.0 from 40.8. Indeed, consumer confidence has shown emerging optimism, primarily on the economic outlook, as the Conference Board’s measure rocketed to 39.2 from 26.9 and the University of Michigan’s sentiment report rose to 65.1 from 57.3. Since risk trends have proven to be the greater driver of price action in the forex markets, a weaker than expected result could trigger flight-to-quality and thus, gains for the US dollar. On the other hand, evidence suggests we could see a surprisingly strong result, which could boost equities and weigh on safe-haven assets.

The other thing to watch is Federal Reserve Chairman Ben Bernanke’s testimony before the Joint Economic Committee, which is also at 10:00 ET, as his comments tend to be gleaned for indications of any sort of bias. The central bank has generally offered up somewhat optimistic comments that the economy and markets have stabilized, and a reiteration of this sentiment could provide a boost to risky assets.

Australian Dollar Could Target 0.7500 Post-RBA Rate Decision Overnight

The Australian dollar started the week off on a strong note, gaining more than 1 percent against the US dollar and Japanese yen, as a broad-based pickup in risk appetite provided a boost to FX carry trades. The commodity dollar will face event risk overnight, though, as the Reserve Bank of Australia is anticipated to leave their cash rate target unchanged at 00:30 ET after unexpectedly cutting the rate by 25 basis points to 3.00 percent last month. However, the Australian dollar may only respond to a surprise rate cut (Credit Suisse overnight index swaps are pricing in a 24 percent chance of a reduction) or a biased monetary policy statement. After the central bank’s last meeting, RBA Governor Glen Stevens said, “The stance of monetary policy, together with the substantial fiscal initiatives, will provide significant support to domestic demand over the period ahead,” suggesting that further reductions were unnecessary. As a result, it will be important to look to Stevens's statement, as signs that the RBA may consider cutting the cash rate target again eventually could weigh on the Australian dollar, while indications of a broadly neutral bias could support the currency. Looking to AUD/USD, 0.7400 serves as immediate resistance, but the level could quickly be broken and price could target the psychologically important 0.7500 mark or the 61.8 percent fib of 0.8524-0.6007 at 0.7562 if the RBA leaves rates at 3.00 percent and issues a neutral policy statement. On the other hand, a 25 basis point cut could weigh AUD/USD back down toward Monday’s lows of 0.7242 or even the 200 SMA at 0.7177.

Euro Breaks Above 1.3400 - 200 SMA Next?

The euro made headway against most of the majors, with the exception of the commodity dollars, helping EUR/USD to break above 1.3400. The currency faces minimal event risk over the next two days, which could leave the door open for EUR/USD to climb toward the 200 SMA at 1.3507. The euro could see major volatility on Thursday though, as the European Central bank will meet. According to a Bloomberg News poll of economists and Credit Suisse overnight index swaps, the ECB will cut rates by 25 basis points to 1.00 percent on Thursday morning. A reduction in line with Bloomberg's estimates could exert bearish pressures on the euro, but where the currency ends the day may have more to do with what ECB President Jean-Claude Trichet says during his post-meeting press conference at 08:30 ET. Many ECB members have indicated that they will announce “unconventional” measures following this meeting, which many have taken to mean credit easing, and if Trichet makes such an announcement, the euro could tumble. On the other hand, if the ECB leaves rates unchanged, indicates that they have no intention of bringing interest rates lower in the near term, or if they put off credit easing, the euro could rally.

British Pound Trading Just Below Key Resistance vs. US Dollar, Japanese Yen

The British pound lost ground against the commodity dollars and European currencies on Monday, and while pairs like GBP/USD and GBP/JPY managed to gain, they were not able to break above key resistance at 1.5070 and 149.00/90. Like the euro, event risk for the British pound will be minimal until Thursday, when the Bank of England is expected to leave rates unchanged for the second straight month. A look at the minutes from their April policy meeting showed that the MPC voted unanimously in favor of leaving the Bank Rate at 0.50 percent and to continue their quantitative easing (QE) program. They also said that there was a "high degree of uncertainty" over the amount of asset purchases that would be necessary to keep inflation at target, and if "the evidence warranted it," the Committee could reduce or expand their program. Ultimately, how the British pound responds will likely depend on the BOE’s QE stance. Signs that the BOE may increase their gilt purchases could weigh heavily on the British pound, especially against the euro, while the opposite (steady rates, no QE expansion) could provide a boost to the UK’s currency.

Terri Belkas is a Currency Strategist at FXCM.