US Dollar Hit By Rising Risk Aversion Despite Stronger Non-manufacturing ISM
The US dollar struggled to rally despite stronger economic data today. Risk aversion is back in play with the Dow dropping by the biggest amount in over a week. The ultimate fear in the financial markets is that this will not just be a one day decline and instead will mark the end of the rally in US stocks. Although we have said often that the rally in the Dow is ripe for a turn, nothing has changed in the past 24 hours. Even though the Chinese stock market fell as much as 7.2 percent last night, it rebounded and ended the day up 2.6 percent. Bernanke commented on the US economy today, but his message has not changed. He expects the housing market to remain a drag on the US economy, but he still expects growth to pick up in the second half of the year and continued to warn that inflation remains a risk. This is the central bank governor’s way of saying, interest rates will remain unchanged for the remainder of the year. Meanwhile service sector ISM hit a one year high in the month of May, confirming that the weakness of the US dollar has not just benefited the manufacturing sector. The underlying components of the ISM report were also strong with advances seen in prices paid, employment and new orders. The one thing that has been weighing on the dollar is reserve diversification. It is confirmed that Syria will be dropping their dollar peg. They are the second country to do so in the past 2 weeks. On May 20th, Kuwait switched to a basket of currencies. Both countries have blamed the weak dollar for boosting import costs and inflation. There is no significant US data on the calendar until Friday, but the movements in the Dow and the rate decisions in Australia, New Zealand, UK and Eurozone will still bring us market volatility.

Euro Reaction to ECB Rate Decision Will Hinge Upon Trichet’s Comments
The Euro held onto its gains today ahead of tomorrow’s much awaited ECB interest rate decision. The market has completely priced in a 25bp rate hike, which suggests that the EUR/USD will probably not budge on the actual rate announcement. Instead, what will move the Euro are the comments from ECB President Trichet at the accompanying press conference. We expect Trichet to remain optimistic about growth but intentionally drop forgo using the words “strong vigilance” regardless of whether he expects to raise interest rates beyond June or not. This was exactly what he did after the last 2 rate hikes in March 2007 and December 2006 even though the ECB moved on to raise rates again in the following months. The bigger surprise to the markets will not be the continually hawkish comments by the central banker but instead more dovish ones. Recent economic data has been mixed. Even though the futures curve is pricing in 4.25 percent rates by year end and the economy could probably handle that, the ECB may want to see how the region responds to the latest rate hike before instituting another one. We mentioned yesterday that it is extremely rare for the ECB to raise rates back to back. Therefore even if rates are to be increased again, it may not be until September at the earliest. This morning’s economic releases were conflicting. Retail sales in the month of April fell short of expectations while service sector PMI accelerated. Aside from the interest rate decision, we also have German factory orders tomorrow.

British Pound: Bank of England Expected to Leave Rates Unchanged
The British pound continued to strengthen following the stronger than expected service sector ISM report. Activity in both the manufacturing and service sector has accelerated, which has helped to boost rate hike expectations. The prices paid component of both of these reports have also accelerated. Even though the Bank of England is expected to leave interest rates unchanged on Thursday, the futures market is now pricing in another 25bp point rate hike in the third quarter and a slim chance of 6 percent rates by year end. Two rate hikes is still a stretch at this point especially with the GBP/USD hovering so close to 2.0. The longer the currency pair remains at that this level, the more it helps to reduce inflationary pressures.

Yen Rallies on Dow Weakness
With the Dow down 80 points today, we have seen reversals in all of the Yen crosses. Most of the pairs are either down for the day or unchanged. Carry traders are beginning to bail, but they haven’t given up quite yet. Bank of Japan Governor Fukui was speaking via teleconference today. He was slightly optimistic about growth and repeated his standard view that interest rates remain accommodative and will be adjusted gradually. The Bank of Japan has little reason to lift interest rates and this week’s data releases are not market moving. Therefore traders should continue to take their cue from the US and Chinese stock markets.

Australian and New Zealand Dollars Rise for Fifth Straight Trading Day
Stronger economic data from Australia has pushed both the Australian and New Zealand dollars to a 15 year high against the Japanese Yen. Although the current account deficit was wider than expected, service sector PMI jumped from 52.8 to 56.1 in the month of May while building approvals increased by 8.2 percent in April. Taken together with the stronger company operating profits reported yesterday, there is a decent chance that GDP growth in the first quarter (which is due for release this evening) will beat expectations. The Reserve Bank of Australia is also set to announce an interest rate decision, but rates are not expected to be changed. This is should be a non-event because the RBA does not release a statement unless monetary policy is altered. The Canadian dollar weakened the most in three weeks ahead of IVEY PMI and building permits. The risk is skewed to the downside for both numbers. New Zealand has commodity prices scheduled for release which could be moderately market moving ahead of tomorrow night’s RBNZ rate decision.

Kathy Lien is the Chief Currency Strategist at FXCM.