Dollar vs. Dow: Plenty of Reasons for Volatility to Continue Next Week
If you watched the stock market today, it is not hard to imagine what went on the currency market. For the past few months, we have either seen carry trades follow the ebb and tides of US stocks or the reverse. The correlation stems from the fact that the yen has become the primary funding vehicle for investors looking to get into US stocks, making the carry trade the poster child of the risk seeking world. The 157 point rally in the Dow today has erased 79 percent of yesterday’s losses bringing carry traders back with a vengeance. The outlook for higher interest rates in countries like New Zealand has sent the NZD/USD to a fresh 25 year high. This very dynamic is what will limit the losses in carry trades even if this is the last hurrah in US stocks. The latest wave of dollar strength, which was limited to the Euro, British pound and Japanese Yen, was triggered by the intraday reversal in yields, the drop in oil prices and the stronger US trade balance. Ten year bond yields hit a high of 5.24 percent, but ended the day in negative territory. Oil prices slipped as the cyclone in the Middle East loses strength. We are also finally seeing the benefits of the weak US dollar. The trade deficit dropped significantly in the month of April as import demand subsided while export demand hit a record high. The increase in exports is the main reason why many economists including Federal Reserve Chairman Ben Bernanke are looking for stronger growth in the second half. In the week ahead, the US economic calendar is light, but US retail sales, producer prices and the Fed Beige Book report are always important. Don’t expect volatility to let up with consumer spending and inflation reports also due for release from countries like the UK and New Zealand next week.

New Zealand Dollar Hits Fresh 25-Year Highs, Be Careful of Bottom Picking in USD/CAD
The return of the carry has taken the New Zealand dollar to a fresh 25 year high against the US dollar and a new 17 year high against the Japanese Yen. The commodity currencies are the best performing currencies today as they shrugged off both dollar strength and commodity weakness. The market expects the Reserve Banks of Australia and New Zealand to raise rates again this year given the strength of economic data for the former and the hawkishness of the central bank for the latter. Australian home loans were released last night and this was just as icing on the cake for a country that has already report very hot GDP and employment numbers. The Canadian dollar benefited from the overall rally in the commodity currencies. The stronger trade surplus and housing numbers offset the weaker employment figures. USD/CAD dropped from 1.1550 to 1.10 in the month of April. The fact that loonie strength did not hurt trade that month means that it has a greater chance of doing so in May and June. Looking ahead, there are key releases from all 3 countries so expect the action to continue in those pairs. Traders should be wary of picking a bottom in USD/CAD before a daily close above 1.0750.

Japanese Government Sees No Risk of a Major Carry Unwind
The rally in the Dow exacerbated the rise in carry trades but those currency pairs already began to trend higher before the US stock market even opened. The initial sell-off in the Japanese Yen was triggered by the nonchalant attitude of the Ministry of Finance towards the carry trade. MoF Watanabe said that there is “no immediate risks of carry trade unwind” and that any unwind would be “small compared to the entire FX market.” The Japanese government is clearly not concerned about the Japanese Yen strengthening. In fact, they probably will welcome it since it automatically tightens the economy and therefore reduces the need for a premature interest rate hike. Despite the weakness in the Yen, companies are not sharing the wealth with the people in the country and as a result, growth has been tepid. Machinery orders for April increased less than expected. The Japanese economic calendar was very light this week but it will pick up significantly in the week ahead with the second release of GDP, CGPI, consumer confidence, the current account, and industrial production due for release. The Bank of Japan will be meeting to decide on monetary policy, but interest rates are not expected to be changed.

Euro Hit by Weak Data; Swiss National Bank Expected to Lift Rates Next Week
All around weakness in European data sent the Euro to a 2 month low. The currency market is cyclical and whenever a currency becomes too strong, we begin to see weakness in the economy, especially if the country is export dependent. The biggest downside surprise today was in German industrial production which fell by the biggest amount in 7 years. Even though the German trade balance was right in line with expectations, the surplus in both Germany and France deteriorated. This is a clear indication that the economy is hitting a plateau and is one of the main reasons why the ECB will postpone any further rate hikes to September at the earliest. The calendar is light next week. The only pieces of data that have the potential to move the Euro are Eurozone industrial production, consumer prices and trade. The more interesting story will be Switzerland, who we expect to raise rates to 2.50 percent.

Heavy Calendar Should Lead to Big Moves in the British Pound
Stronger economic data has driven the British pound higher against the Euro, Japanese Yen, and Swiss franc but unfortunately, that strength did not extend to the GBP/USD. As correctly forecasted by the increase in manufacturing PMI, industrial production grew by a more than expected 0.3 percent in the month of April. House prices also continued to accelerate bringing the annualized pace of growth up 8.5 percent from 8.4 in the month of May. The UK has one of the busiest calendars next week with producer prices, consumer prices, employment and retail sales due for release. So expect to see big moves in the British pound.

Kathy Lien is the Chief Currency Strategist at FXCM.