Dollar Clawed by Bear-New Risk in the Buck?
For most of last week trading in EURUSD was lackluster at best as the pair continued to travel the familiar 1.345-1.3350 path remaining range bound as it has the week prior and the week before that. Indeed up until on Friday, the bias in the EURUSD was actually dollar bullish as the most recent economic data proved supportive of the greenback. Housing Starts and Building Permits both printed better than expected at 1474 and 1501 respectively suggesting at least for the moment that the sector has stabilized. LEI recorded a better reading as well at 0.3% vs. 0.2% and Philly Fed rose to 18 from 4.2. On Friday however, the story took a 180 degree turn as fears over the Bear Stearns CDO fiasco swept across all capital markets. The Dow dropped –185 points while the greenback which usually trades inverse to US equities also lost ground. The key change in the sentiment was driven by a fears that the Bear Stearns hedge fund problems were only the tip of the iceberg, that may force a downward revaluation in trillions of dollars worth of housing related securities creating massive liquidity problems in US financial system which in turn would materially increase the risk profile of all US assets.

Next week the Bear Sterns story will no doubt continue to hover in the background but focus will once again turn to the housing sector as both Existing and New Home Sales are due Monday and Tuesday. The markets are looking for weaker data and it will be especially interesting to see the impact of rising mortgage rates on the transactions in May, although the full effect of the spike in rates is not likely to be reflected until June’s data. In either case, the calendar offers little cheer to dollar longs, but an inline or slightly better than expected result could spur some dollar buying given the generally negative positioning on the unit. End of the week brings FOMC which is unlikely to offer anything new as the Fed is forced to remain hawkish given the underlying strength in inflation gauges. Finally perhaps the most interesting report of the week will come last as both Personal Spending and Personal income are due Friday. Another month of negative spreads (where spending exceeds income ) will weigh heavy on the dollar suggesting that the US consumer is totally tapped out.

Does the Euro Have Enough Momentum for 1.3500?
Disappointing economic data did little to halt the Euro’s week-long ascent, with the single currency reaching fresh monthly highs on continued dollar weakness. Prominent German IFO and ZEW business outlook surveys surprised to the downside, overshadowing the continued climb in the Euro Zone Composite PMI and shallow fall in Industrial New Orders. Yet the usually market-moving data was not enough to slow the Euro’s impressive gains. This was nowhere more prominent than in the EURJPY, which ended the week at fresh record-highs despite strong declines in global equity markets. Euro-Yen demand notwithstanding, it is unclear whether the single currency can continue its advance against the US dollar. The $1.3500 mark remains a very important technical and psychological hurdle that will take considerable buying pressure to overcome. Given a relatively empty European calendar through the coming week of trade, such EURUSD bids will likely come on a shift in US dollar sentiment.

Key event risk for the Euro will come on French and German employment reports, but post-news reactions will likely pale in comparison to those following US FOMC and Housing data. It is no secret that markets are unsure of what to expect from the US central bank, leaving the future of EURUSD price action in the balance. The recent correction in bond yields suggests that markets fully expect the central bank to stand pat at 5.25 percent through year-end, but it serves to note that any surprise changes in the FOMC statement could force large moves in the Euro-US Dollar pair. Though somewhat unlikely, a dovish shift could send bond yields reeling and force a large-scale correction in the US dollar. This could easily push the Euro towards 1.3550 and eventually a retest of all-time highs. Financial markets around the world remain on edge to hear what Fed Chairman Ben Bernanke will have to say on the future of monetary policy, with an otherwise packed week of data providing no shortage of excitement in early summer trade.

Yen Data Unlikely to Force Shift in Sentiment
The Yen showed few signs of slowing its poor performance through recent trade, dropping to all-time lows against the Euro and a multi-decade worst against the Pound. In doing so it has held firm as the most undervalued currency by common estimates—narrowly beating the downtrodden US dollar. Economic data was relatively scant on the week, with a largely ignored Merchandise Trade Balance disappointment and a positive surprise in the All Industry Index doing little to move the domestic currency. Of course, investors have remained largely indifferent to Japanese fundamental news, leaving the currency to trade off of global risk appetite and the performance of highly speculative assets. This fact makes it especially interesting to note that the JPY continued lower despite tumbles in US equity markets. The Yen has slowly been breaking its correlation with equity market volatility, but a re-pricing of risk could easily boost the currency against its higher-yielding counterparts. A full week of event risk should help guide overall price action, but we do not expect individual reports to garner much attention absent truly surprising results.

We will see the usual month-end flurry of data out of the world’s second-largest economy, but it is unclear that this will force particularly volatile moves from JPY currency pairs. Retail Sales, Industrial Production, and the National CPI reports are all due within a three day stretch. Of course, given a background of tepid economic growth and exceedingly low inflation, at-consensus prints will do little to alter outlook for Japanese monetary policy. The Bank of Japan has made it exceedingly clear that it does not plan on raising rates through the short term, but one must assume that significantly higher-than-expected inflation number would alter its stance. Barring such an outcome, we will look to Global equity markets and levels of implied volatility to guide Japanese Yen price action. Though the JPY’s correlation with the US S&P 500 Volatility Index (VIX) has broken down through the past week of trade, we would expect that prolonged equity tumbles may start to take their toll on the highly oversold Yen.

Can Pound Clear 2.000?
The minutes of BOE Monetary Policy Committee meeting revealed a far closer vote to raise rates than the market anticipated, indicating that the UK Central Bank maintains its hawkish bias even in the face of cooler inflation gauges and slowing consumer demand. The MPC voted 5-4 to keep rates steady in June against expectations of a 7-2 vote by most market analysts. Governor King who voted for a hike found himself with the minority for the first time since August of 2005. With oil prices hovering at $69/bbl, housing continuing to post double digit gains and money supply expanding way beyond the BoE comfort level, the benefit of doubt must go to pound longs as the present operating assumption in the market is that BoE may go to 5.75% as early as next month if the economic data remains relatively robust. Sterling easily cleared the 1.9900 level on the news and by the end of the week was within a whisker of the 2.000 figure as currency market started to price in 5.75% rates.

Next week the calendar is extraordinarily light with only GDP and GFK Consumer Confidence survey of any import of the docket. The GDP is expected to print in line with recent trend and by itself is unlikely to motivate the BOE to raise rates further. However, the unexpectedly large growth in money supply figures is likely to continue to weigh on the policymakers minds, with UK media suggesting that the MPC members are frustrated with the recent lags between policy action and market impact. Nevertheless, the true surprise could come from lower than expected figures in both GDP and Consumer Confidence which would force a rethink of the present operating assumption that 5.75% in July is done deal.

Swissie Inflation Gets Hot
In Switzerland PPI prices printed at twice the expected rate gaining 0.9% vs. 0.4% forecast. In retrospect, given the weakness in the franc and the persistently high energy prices the increase in the Swiss price levels was not surprising. It was however quite important to the market. A greater than expected rise in inflation gauges is the only economic factor that is likely to motivate the SNB to raise rates by 50bps points rather than the standard 25bp at the next meeting in September.

EURCHF which reached record highs at the start of the week reversed for more than 100 points on the news dropping to 1.6545 by the end of the week. Still the pair continues to be driven by huge momentum from the carry traders and it is far from clear whether the PPI news was enough to have reversed the one way price action of the past several months. Next week KOF survey which is considered to be the most important economic release on the Swiss calendar may hold the key to further Swissie gains. If the number prints above 2.00 the possibility of a 50bp hike from SNB will become much stronger.

Canadian Dollar Needs Results from BoC for Further Gains
The Canadian dollar underwent a dramatic transformation over the past month. In only two and a half months, the loonie rallied more than 1,200 points against the US dollar, 1,500 points versus the euro and 1,800 against the Japanese yen. These massive gains were spurred on by a big shift in fundamentals that slowly turned the Canadian interest rate curve towards another rate hike. However, the good times may have come to end. After moving in to price in a possible rate hike or two from the Bank of Canada this year, the currency may have in fact overshot the fundamentals. This past week’s economic calendar has actually cast doubt on a the necessity of a 25 basis point hike in July – much less two quarter point hikes anytime this year. Just after the last BoC meeting, the fundamentals were clearly showing pressure in both growth and inflation trends. It took only one week’s worth of data to turn the tides. At the beginning of the week, the consumer inflation numbers crossed the wires with disappointing results. The annual read on headline CPI held steady at 2.2 percent; but the central bank’s favored core figure actually decelerated more than expected to a similar 2.2 percent gait. While economists anticipated the contraction, it still brings the reads very close to the 2.0 percent target rate. Taking on the inevitability of a rate hike from another angle, consumer spending also took a hit in its most recent round of data. Retail sales fell well short of expectations with a 0.4 percent increase.

In the week ahead, the economic calendar thins out; but rate speculation will almost certainly heat up. Some lower tier inflation indicators will measure pressures further up the pipeline. Both industrial product and raw materials price indices for May are expected to drop substantially from their previous readings. However, traders and economists are unlikely to pay much attention to this data as they seem pretty certain of a rebound in the more crucial inflation numbers further down the line. The real fireworks will be set off by the April Gross Domestic Product number. In the span of a few weeks, the consensus has evolved from a forecasted increase over the previous month, to a repeat figure, to a weaker number. The market is now looking for a 0.2 percent pick up in growth for the period. While this would certainly add to the impressive positive trend, it would also usher in another source of doubt. Should expansion cool, it would certainly sabotage inflation pressures and open the doors to cooler growth and prices in the medium term – right in line with what the central bank’s objectives.

Aussie Has the Yield Advantage Without the Pesky Central Bank
There were few indicators for Australian dollar traders to work with last week, and there are just as few scheduled for release this week. Looking back, there were only two indicators that truly around the fundamental communities interest: the Westpac Leading indicators index and first quarter construction activity. Calling the Westpac’s number a ‘Leading’ gauge seems an oxymoron. While the indicator does bring together a broad array of readings to measure the overall health of the economy, it is a compilation of data from April – fully two months behind us. This contradiction is clearly taken note of in the market seeing as how the Aussie dollar saw little to no reaction on the release of a big pick up for the month. From a 0.1 percent read in March, this month’s number crossed the wires at 0.7 percent. However, putting everything into perspective, this report is prone to considerable volatility – evidenced by the 1.0 percent jump in February. The more pertinent indicator for growth and interest rate speculation was the Australian Bureau of Statistics’ first quarter dwellings starts number. With no official consensus to use as a benchmark, the construction activity report showed a healthy 1.3 percent pick up through the opening months of the year while also garnering a big positive revision for the previous number. However, once again, this indicator was ignored since it is open to considerable volatility and it contributes little to what traders care most about – yields.

Looking out over the days ahead, the economic calendar looks like a reflection of last week’s docket. Once again we will have a leading index and housing report. The Conference Board’s attempt at projecting growth will interest market participants even less than the Westpac’s. Not only is this report wrapping up numbers for April, it has the disadvantage of the being the second read to do so. On the same day, a little more up to date HIA New Home Sales figure for may will cross the ticker. There is no consensus and its official release time is unknown, though this will not likely matter much. Most analysts are aware that housing trends are strong in Australia; and they have already been factored into growth and rate models. So, amid this impotent indicators, what will move the market? Interest rates. Though the RBA doesn’t meet again for a while, and there has been little real data altering expectations for the local policy group, rates have undoubtedly guided price action. The kiwi dollar has played more the a small hand in driving its Australian counterpart. The Aussie and kiwi dollars are the top yielders in the high liquidity echelons. The NZD has had no trouble stoking its own fires, as the RBNZ has boosted rates three meetings in a row and has practically promised that there is more to come. While the RBA is far less hawkish, it has caught a strong draft from the kiwi as capital flows into the carry. Looking ahead, the Aussie may actually offer a more appealing trade for the carry crowd. Though the kiwi gives a higher yield, it is open to serious risk with the RBNZ repeatedly trying to batter the currency down. What’s more, the Australian economy is far more stable, and nothing promotes long-term trades like long-term growth.

Trio of Significant Reports Highlights Kiwi Event Risk
The New Zealand dollar cast aside concerns of further RBNZ currency intervention, rallying to fresh multi-decade highs in defiance of the central bank’s actions. Last week we wrote, “It seems increasingly likely that the RBNZ will once again intervene by selling its domestic currency, but it remains anyone’s guess as to whether this will be effective in halting the currency’s longer-term advance.” Recent price action shows that yield-hungry speculators are currently winning the battle, but is likewise clear that the war is far from over. The Reserve Bank proved that it has not given up; the New Zealand dollar fell a whopping 60 points on reported official selling through late Friday trade. Given that the central authority tends to place its market orders during particularly illiquid hours, this boosts the prospect of fresh selling through early Sunday trade. A veritable minefield of significant economic reports may have the final say in Kiwi appreciation, with Trade Balance, Current Account, and Gross Domestic Product all due within midweek.

Due up first will be the all-important Trade Balance report. Analysts predict that net exports turned positive through the most recent sampling period on agricultural export strength, but pronounced currency appreciation leaves risks to the downside for the trade figure. The result will be especially important given a political atmosphere hostile to the Kiwi’s incredible gains. The next night’s Current Account report will have similarly significant implications for different reasons; given tremendous foreign interest in New Zealand debt, the deficit is expected to stay at an alarmingly high 8.7 percent of domestic GDP. Markets have previously shown concerns that such dependence on foreign capital would lead to a downgrade of the country’s top Sovereign debt rating; given such high borrowing rates, some lay doubt as to whether the government would be fit to repay all obligations. Finally, Thursday holds one of the important economic data releases for any economy: the country’s Gross Domestic Product growth. Though the figure will be greatly delayed at a fully quarter late, it may give markets insight as to New Zealand’s growth prospects for the rest of 2007. Disappointments will surely prove a detriment to the central bank’s tightening of monetary policy and slow the Kiwi’s seemingly unflappable ascent.

Watch for key surprises in the three headlining reports; worse-than-expected data may be enough to deflate the NZD and support the Reserve Bank of New Zealand’s drive to reign in excessive currency appreciation.

Boris Schlossberg is a Senior Currency Strategist at FXCM.