US Dollar, Japanese Yen Stage a Comeback as Risk Sentiment Take a Turn for the Worse

The US dollar and Japanese yen both staged notable rallies on Wednesday amidst a broad shift in sentiment, which weighed on FX carry trades and US equities, with the DJIA ending the day down 66 points and the S&P 500 losing 13 points. Looking to the news of the day, Federal Reserve Chairman Ben Bernanke testified in front of the House Budget Committee and spoke about economic developments, the economic outlook, financial market conditions, fiscal policy, and Federal Reserve transparency. Bernanke's comments ultimately weren't very market-moving and failed to provide a boost to investor sentiment. The same goes for ISM non-manufacturing, which rose to 44.0 in May from 43.7, with a breakdown showing that business activity, new orders, and employment all continue to slow, though the latter has started to fall at a slower pace than in previous months. This move in the employment component suggests that Friday’s non-farm payrolls report will likely show that job losses remain high, but that the pace of declines are starting to slow.

British Pound Down Ahead of BOE Meeting – What to Expect

The British pound took a hit against the US dollar, Japanese yen, Swiss franc, and euro, with the daily charts showing that GBP/USD formed a bearish engulfing candle. The move had more to do with risk appetite, as usual, and UK fundamentals were rather optimistic once again. Markit Economics said that PMI for the UK services industry rose to 51.7 in May from 48.7, indicating growth for the sector for the first time in a year.

All told, the data adds to evidence of stabilization in the economy and also suggests that the Bank of England will leave rates unchanged on Thursday for the third straight month at an all-time low of 0.50 percent. Ultimately, how the British pound responds to the rate decision will likely depend on the BOE’s QE stance in their policy statement. 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, though the markets are just as likely to show no reaction in this case.

Euro Tumbles as Q1 GDP Gets Revised Lower - ECB Meeting to Detail Credit Easing Program

While the euro was down 1 percent against the US dollar, the currency actually gained more than 1 percent against the Australian dollar and Canadian dollar, and also surged over 2 percent versus the New Zealand dollar. Nevertheless, most were watching the EUR/USD reversal from 1.4330, especially as daily RSI came down from overbought levels, signaling a turn. Meanwhile, Eurostat reported that Euro-zone GDP figures for Q1 proved to be worse than expected as the annualized rate was revised down to -4.8 percent from -4.6 percent, though the quarterly rate held at -2.5 percent. A breakdown shows that household spending contracted 0.5 percent during Q1, gross fixed capital formation plunged 4.2 percent, government spending stagnated, exports plummeted 8.1 percent, and imports fell 7.2 percent. Adding to evidence of lackluster growth, Markit Economics released their composite Purchasing Managers' Index (PMI) for the Euro-zone's manufacturing and services sector. While composite PMI did rise to 44.0 in May from 41.1, readings below 50 still signal a slowing in business activity, suggesting that the contraction in the Euro-zone economy may not be accelerating, but it remains far from recovery mode.

On Thursday, the European Central Bank (ECB) will likely leave rates unchanged at 1.00 percent. However, 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. Indeed, in May the ECB announced that they would buy 60 billion euros worth of covered bonds issued in the Euro-zone, but that details wouldn’t be released until after this upcoming meeting. As a result, much attention will be paid to which bonds will be bought and how the ECB plans on going about buying them, as direct buying from issuers would effectively supply them with direct funding, whereas the purchase of existing covered bonds would support prices and drive down yields.

Australian Dollar Sees Short-Term Boost From GDP Results, But Carry Trade Selloff Takes Its Toll

The Australian dollar initially gained last night across the majors on news from the Australian Bureau of Statistics, which surprisingly said that the economy grew by 0.4 percent in Q1 from the previous quarter, when GDP fell 0.6 percent. Meanwhile, the annual rate eased to a 0.4 percent pace as well from 0.8 percent, marking the sixth straight slowdown, though this certainly beat expectations of an all-out contraction. A breakdown of the report showed that consumer spending rose 0.6 percent, government spending increased 0.3 percent, and exports jumped 2.7 percent. Weaker points could be found in business investment, which dropped 6.1 percent, while imports slumped 7 percent. That said, the risk aversion that emerged during European trading eventually weighed FX carry trades down across the board, making the Australian dollar the third weakest of the day as AUD/USD plunged 2.51 percent and AUD/JPY dropped 2.28 percent.

Canadian Dollar Loses Ground - BOC May Determine Next USD/CAD Move

The Canadian dollar traded with the rest of the commodity dollars on Wednesday, as the currency lost 2.6 percent against the greenback. The Canadian dollar could see a further pickup in volatility on Thursday at 9:00 ET as the Bank of Canada is expected to leave rates unchanged at 0.25 percent, following their surprise 25 basis point reduction on April 21. During that April meeting, the BOC made it clear that they intended to leave rates at that level though June 2010, but a bombshell came from the BOC’s Monetary Policy Report a few days later, as they left the door open to quantitative easing (QE) and credit easing if nominal interest rates start to fall below zero. Indeed, the Bank stated that while they could cut rates to zero in theory, it would ultimately "eliminate the incentive for lenders and borrowers to transact in markets, especially in the repo market." As it stands, core CPI has held at a fairly robust 1.8 percent in April, suggesting that inflation remains high enough to suggest that QE will not be on the way anytime soon.

Terri Belkas is a Currency Strategist at FXCM.