US Dollar Rally Continues as DJIA Tests Key Support at 8600

The US dollar was one of the biggest winners on a day when equities and FX carry trades took a beating, indicating that the greenback hasn’t lost its luster as a “safe haven” asset. Looking to the news of the day, the US Treasury said that foreign demand for US assets rose more slowly during the month of April, as total net purchases of long-term equities, notes and bonds increased by a net $11.2 billion, down from $55.4 billion in March. Meanwhile, the New York Fed’s “Empire” manufacturing index fell more than expected to a reading of -9.41 in the month of June from -4.55, signaling a deeper contraction in business activity. A look at the breakdown of the report shows that the shipments component fell negative once again after rising into positive territory last month for the first time since July 2008. In fact, every other component - including prices paid/received, new orders, inventories, and number of employee - remained negative, suggesting that the manufacturing sector is far from recovery.

According to Bloomberg News, the Commerce Department may report on Tuesday that US housing starts and building permits staged a healthy rebound during the month of May. Indeed, housing starts are projected to have risen to an annual rate of 485K from a record low of 458K, while building permits are forecasted to have risen to 508K from a record low of 498K (revised up from 494K). This will be one of the first housing-related indexes released for the month of May, but as we saw with last month's results, it isn't necessarily a great leading indicator as new and existing sales improved while starts and permits tumbled. Nevertheless, surprisingly strong results could offer a boost to investor sentiment, while unexpected declines could lead risk aversion to dominate once again.

Euro Tumbles as ECB Says Banks Stand to Lose Another $283 Billion

The euro fell sharply against the greenback after the European Central Bank (ECB) said that commercial banks in the region may stand to lose another $283 billion by the 2010 due to write downs. Indeed, European banks have not been as quick to realize losses as US banks have, suggesting that negative news for the European financial sector is likely to seep out for quite a while longer. Looking ahead to Tuesday, Eurostat has already estimated that Euro-zone inflation stagnated during the month of May, but traders should still keep an eye on the final reading of this report. Indeed, Eurostat may confirm that CPI stagnated on both a monthly and annual basis, the lowest readings on record. However, the European Central Bank has already stated that they anticipate that CPI growth will “decline further and temporarily remain negative over the coming months, before returning to positive territory by the end of 2009,” which may prevent speculation from arising about the prospect of additional rate cuts. Nevertheless, surprisingly weak results could still weigh on the euro upon release.

Swiss Franc Mixed as Inflation Measure Plunge to 22+ Year Low

The Swiss franc ended on a mixed note, losing against the British pound, US dollar, and Japanese yen while gaining against the commodity dollars and euro, as the Swiss producer and import price index fell 0.3 percent in May, dragging the annual rate down to -5.0 percent, the lowest since December 1986. Indeed, lower commodity prices and a stronger Swiss franc, which dampens import prices from the Euro-zone, have both been contributors to the drop in Swiss inflation. This turns our attention to Thursday, when we’ll see a policy announcement from the Swiss National Bank (SNB). The SNB is likely to leave their 3-month LIBOR target range unchanged at 0.0 percent – 0.75 percent, but the thing to watch for in the SNB’s subsequent policy statement is talk of FX intervention. Indeed, the SNB’s last statement on March 12 indicated that the central bank wanted to “prevent any further appreciation of the Swiss franc against the euro” in an effort to “counter the risk of deflation and of a dramatic deterioration in the economy.” Similar comments have the potential to drive the Swiss franc lower upon this 3:30 ET release, while a neutral policy stance and no mention of currencies will likely lead the Swissie higher.

British Pound Down vs. US Dollar, Japanese Yen Ahead of UK CPI Report

The British pound was actually one of the stronger currencies of the day on Monday, except when it came to GBP/USD and GBP/JPY, as the pairs fell toward near-term support levels at 1.6250 and 159.00, respectively. The British pound could come under pressure on Tuesday, though, as UK inflation data will be released. While the May reading of UK CPI is projected to rise 0.3 percent, following a 0.2 percent gain in April, the annual rate may fall to an annual rate of 2.0 percent from 2.3 percent. Such a result would mark a 19-month low and would also bring CPI in line with the Bank of England’s (BOE) target. Nevertheless, the central bank has said in the past that they expect inflation to full much lower later in the year, and greater-than-expected declines could trigger British pound declines amidst fears that CPI will eventually fall negative.

Japanese Yen Gains as FX Carry Trades Tumble – Will the Bank of Japan Have Any Impact on the JPY Crosses?

The Japanese yen rallied across the majors, even beating out the US dollar, as a more-than 3 percent plunge in some European equity indices and a 2.13 percent drop in the DJIA signaled wide-spread risk aversion, weighing on FX carry trades. While risk trends will likely continue to determine price action for the Japanese yen crosses, the currency will face some event risk overnight. Just before midnight, the Bank of Japan is anticipated to announce that they are leaving rates unchanged at 0.10 percent, but this is not the part of the central bank’s announcement that will garner the most attention. Instead, the FX markets may only respond to the sentiment reflected in their subsequent policy statement. After the BOJ’s last meeting, they raised their outlook on the economy for the first time in nearly 3 years, saying that “economic conditions have been deteriorating, but exports and production are beginning to level out.” There is speculation that the BOJ will upgrade their outlook once again, and if this is the case, the Japanese yen could gain on a very short-term basis. On a longer-term basis, though, risk trends have been driving price action and the impact of positive BOJ commentary may not go very far.

Terri Belkas is a Currency Strategist at FXCM.