Dollar Rebounds As Risk Liquidated Across the Board
It didn’t matter that Existing Homes Sales in US plunged another –3.8% or Durable Good came up short of expectations at 1.4% or that New Homes fared even worse than the existing stock of housing. The theme last week for speculators the world over was liquefy, liquefy, liquefy. As equity markets plunged and commodities corrected, capital came flocking back into the greenback. As we explained on Friday, “The greenback rally appears to be driven by technical factors as many speculative trades from equities to commodities to the carry trade are unwound and those assets are parked in dollars for the time being.”

The fears over the sub-prime problem have finally been realized after last week commentary by County Wide Finance chief executive Angelo Mozilo. He noted that he doesn't expect the U.S. housing market to rebound this year or next. With massive resets of Adjustable Rate mortgages still facing the market and a very pronounced tightening of credit conditions over the past several months, the housing recession is likely to persist and weigh on the overall economy. Therefore while the dollar may continue to benefit from the technical unwind its rally may be short lived if the economy falters further. Fed fund rates have already plunged handicapping a rate cut by December to 5% from the current 5.25%. Should US rates be lower, the dollar could resume its decline as capital will resume its search for higher returns.

The question of whether the Fed will cut or not will depends largely on the state of the growth in the economy. That’s why next weeks data is likely to be scrutinized even more closely than usual as traders look for any clues of a significant slowdown. After two consecutive months of negative spreads between consumer income and spending the market is looking for an improvement. However, should the number print negative again it could put further pressure on the buck, indicating further deterioration of consumer balance sheets. Nevertheless, the true test of the strength of the US economy will come later in the week as all eyes will focus on ISM and NFP data. If that news prints in line showing slow but steady expansion it may pacify the markets for the time being.

Euro Feeling the Weight of Its Gains
On Tuesday the flash PMI reading for the Euro-zone surprised to the downside and we noted, “EZ advance PMI readings fell to 54.8 - materially weaker than the 55.5 forecast. While EZ manufacturing remains well above the 50 boom/bust line, today’s flash estimate registered its lowest value in nearly a year and half slipping below the 55.0 level for the first time since February of 2006. Although, like the consumer readings, the manufacturing data was somewhat ameliorated by the fact that New Industrial Orders rebounded to 1.7% from -0.6% drop the month prior, today’s report nevertheless suggests that EZ manufacturing recovery has peaked under the pressure of high exchange rates.” That data was further reinforced by the decline in the IFO survey leading us to conclude that, “The producers in the EZ have been surprisingly effective in coping with the competitive pressures of a strong currency however such efficiency cannot last forever and the effect of a strong euro is likely to dampen demand sooner rather than later. “

Indeed, while the dominant theme in the markets last week was risk aversion which triggered a technical rebound in the dollar, the sub-story was the possible peaking of export dependent Euro-zone growth due to the appreciation in the EURUSD. With both manufacturing and tourism likely affected the question facing euro bulls is whether internal demand can pick up the slack and maintain growth momentum. Next week’s employment numbers and Retails sales figures should provide some possible answers as to the depth and the strength of the EZ recovery.

Yen Rises as Risk Appetite Falls
On Friday we wrote, “Yen has been the key beneficiary of the this move to risk aversion gaining more than 200 points since yesterday. However, the unit lost some momentum in late Asia trade as USDJPY once again traded above 119.00 figure. Despite the power of the carry trade unwind, the yen is unable to gather even a modicum of support from the fundamentals. Overnight Japanese data was horrid with Retail Trade slipping to -0.4% and CPI continuing to contract. Japanese retail traders have been one of the staunchest sellers of their own currency and they stepped in to buy the dips in USDJPY tonight helping to stabilize the fall.”

Next week the tug of war should persist as the forces of risk aversion will continue to cover their yen shorts and the still potent demand of carry traders who see nothing on the economic horizon to expedite the BOJ glacial pace of monetary tightening will try to buy every dip in the yen crosses . Indeed after last weeks lackluster data chances of an August rate hike have decreased. The market will now focus on the Overall Household spending figures which will be critical to determining the health of the consumer. Expectations are for 0.7% rise. If the number prints in line, the yen may get a boost ob speculation that an August rate may yet take place, but a miss would almost certainly take that scenario off the table. None of this however will assure further yen weakness if the turmoil in global equity markets continues. In a battle between carry trades and risk aversion, the latter has the upper hand.

British Pound Punished on Risk Aversion, Potential for Bounce?
The British Pound saw an extraordinarily volatile week of trade, setting fresh 26-year highs before matching its worst single-week decline since September of 2006. A remarkable carry trade unwind forced traders to liquidate overextended GBP longs across the board, sparking especially noteworthy moves against the oversold Japanese Yen. Economic data was relatively sparse on the week, but fears of global credit tightening led a flight to safety in virtually all global asset classes. Such a dynamic has undoubtedly hurt outlook for the British currency, but it remains to be seen that this unwind will continue through the short term. According to our Technical Currency Analyst Jamie Saettele, the Sterling is due for further decline against the Swiss Franc through coming trade. Outlook for Cable’s performance against the US dollar is similarly pessimistic; the GBPUSD may not see significant support until a test of a year-long trendline near the psychologically significant 2.0000 mark. From a more fundamental standpoint, the British currency will see little boost from economic data through the coming week. A pending Bank of England interest rate decision is highly unlikely to show a rate increase, and the central bank does not release commentary on unchanged policy.

The early going will see little foreseeable event risk on the second-tier GfK and Nationwide Consumer Confidence surveys, but continued volatility across financial markets may nonetheless make for choppy trading. This will almost entirely depend on the performance of risky assets across the world, with Sunday night’s Asian market open to prove especially important for the outlook on the week ahead. Given that the carry trade is inextricably linked to Japan and other regional markets, speculators will likely show their true colors and outlook for high-yielding currencies as soon as they hit their desks at the open. Late tumbles in North American equity markets suggest that the Japanese Nikkei index may open trade substantively lower, but this does not rule out a later rebound on improved appetite for risk. Pending such a turnaround, we could see the British Pound catch some relief against the Japanese Yen and other lower-yielding currencies.

Swissie Looks to Slide on Diminished Rate Expectations
The Swiss Franc lost ground against the US dollar, as softened interest rate expectations hurt outlook for the European currency. All was not lost for the Swissie, however, with an overall theme of carry trade unwinds sending the CHF significantly higher against the high-flying British Pound and Euro. Speculators scaled back overextended positioning in the popular GBPCHF and EURCHF pairs, but it remains to be seen if such moves will be sustained through the short term. Swiss interest rate futures have been steadily on the rise, leaving implied rate expectations lower through the end of the year. Once a key source of Swiss Franc support, the falling future yields threaten to derail what was a promising rebound in the downtrodden currency. Limited economic data stepped in to boost the currency’s cause, however, with the KOF Institute Leading Index rising well-above consensus forecasts at 10-month highs of 2.13 in July. The gain from June levels represents the sixth consecutive increase in the index, which certainly bodes well for outlook on domestic growth. Yet such data may do push the CHF higher if higher price pressures do not follow. More specifically, we will need to see the upcoming week’s Consumer Price Index data impress for the Swissie to outperform is European and North American counterparts.

Event risk will pick up in the coming days, with market-moving SVME Purchasing Managers Index and CPI numbers to drive foreseeable volatility in CHF pairs. The former is likely to show that industrial growth remains healthy in the small European economy, yet a positive result will come to little of the later CPI data disappoints. A soft Producer and Import Price Index reading suggests that the Consumer-linked measure may be similarly subdued, keeping pressure off of the Swiss National Bank to tighten monetary policy through the end of the year. Futures currently show that markets expect at least 50 basis points of rate increases through December. Whether or not this comes to bear will hinge on upcoming inflation data, and surprises in either direction will likely drive strong moves in the CHF.

Canadian Dollar Makes Big Technical Turn, Data Comes On Line
Though it was a relatively quiet week for Canadian fundamentals last week, the loonie was on the move. The mood surrounding USDCAD changed dramatically from through this relatively short period. In the first half of the week, the pair was certainly moving in favor of the Canadian currency as traders bid it to a new record high (at least 30 years at least) against its US counter part. The last gasp of the loonie’s long-held rally came on Tuesday when a surprise jump in retail sales drove the single unit one percent higher. According to Statistics Canada’s report, Canadian consumers spent 2.8 percent more at retailers shops in May, the biggest one-month increase in nearly a decade. This report led some market participants to label this indicator as proof positive that the central bank would pursue another hike at its next meeting on September 5th. However, after this release and the sharp move, the high loonie quickly came under the spot light with no other market-worthy indicators due for the rest of the week. With no technicals in sight and fundamental traders having to weigh the possibility of further BoC rate hikes against the extreme exchange rate, it seemed only a matter of time before the market sought relief. The reprieve came relatively quickly on Wednesday when whispers of risk aversion started to earn headlines. Global equity markets marked the start of a violent turn while yields on corporate and government bonds started to back off. When FX traders looked to cut their own risky trades, long Canadian dollars seemed to top that list.

For the week ahead, the Canadian dollar will likely come back under the umbrella of risk aversion. Should any of the major ‘high-risk’ trades (i.e. equities, carry trades, etc.) continue to decline, it could easily sweep the up Canadian dollar with. Since the unit is still within arms reach of record highs against the US dollar – which happens to be the most liquid and attached to the world’s largest economy - it is still deep in overbought territory. However, should these large equity corrections prove to be temporary like the shake up in late February and the term risk aversion fade into the background, fundamental loonie traders will still have a number of releases from the economic docket on which to base their trades off of. The data push will begin early with Tuesday’s GDP report for may. After growth stagnated in the previous month, the expected 0.4 percent increase is looking pretty good. Following up on the heels of this top-tier indicator, the Ivey PMI and building permits releases will put in for price action. Both are expected to cross the wires with disappointing results.

Australian Dollar Sustains Heavy Damage, Can An RBA Hike Help?
The Australian dollar was looking at heavy losses across the board last week. Indeed, the only place the Aussie looked like it was able to hold any kind of bid was against the New Zealand currency, which was consequently embroiled in a tumble of its own. Looking back over the events for the week, there were two clearly conflicting forces playing on the Aussie dollar. Arguably the overwhelming component of this specific move was a global bout of risk aversion and subsequent carry trade unwinding. While the seeds for such a move have been incubating for some time, it seems the trigger for a wave of risk aversion came from further grumblings in the US housing market. From there, the damage spread as global equity markets pitched into sharp declines marked by major technical breaks in the some of the leading benchmark indices. No matter where investors had their capital: international stocks, government yields, corporate credit spreads or currencies; the impact was felt everywhere. For the FX market, the impact was clearly read in the majors and the crosses. From both sides of the lucrative carry (the Japanese yen and Swiss Franc to the Australian and New Zealand dollars), the shift was dramatic. Now, the question remains, is this the true turn in risk aversion or is this another round of pressure relief that draws speculators back to high yielding/high risk trades.

The other major issue controlling price action for the Aussie dollar last week was speculation surrounding the likelihood of a rate hike from the RBA. There were only two noteworthy indicators crossing the economic calendar over the period - PPI and CPI - and neither sealed the deal for the central bank. The factory-level inflation number decelerated to a three-year low 2.3 percent in is annual figure. At the same time, the favored consumer report slowed to 2.1 percent - nearly inline with the RBA’s target. On the other hand, core inflation gauges are just below the 3.0 percent tolerance limit. Looking at the calendar for the week ahead, the rate debate will only heat up. There are a number of growth and inflation reports scheduled for release that will add to the outlook. Key among this list of market-worthy reports are the NAB’s quarterly business sentiment gauge, retail sales for the second quarter and TD Securities’ leading inflation figures for July. If the RBA doesn’t have the ingredients for a hike come August 7th, a move may be deferred from some time as the national election closes in.

Kiwi Loses Support on Carry Trade Unwind, Dovish Rate Outlook
The New Zealand Dollar saw its worst weekly performance since March, as a sharp carry trade unwind and a dovish central bank doomed the currency to a pronounced sell-off. A mid-week Reserve Bank of New Zealand interest rate hike actually led to a subsequent Kiwi drop. The largely expected rate increase came on increasingly dovish commentary from RBNZ Governor Alan Bollard. In the attached communiqué, Bollard claimed “New Zealanders have been showing early signs of moderating their borrowing. Provided they keep this up, and the pressure on resources continues to ease, we think the four successive OCR increases we have delivered will be sufficient to contain inflation." Subject to the mentioned caveats, he essentially told markets that the RBNZ may be done in its recent tightening cycle—removing a key pillar of support from NZD pairs. The Kiwi still maintains one of the highest yields of any major world currency pair, but an outlook for unchanged rates certainly stands to push it lower against currencies with rate increases on the horizon. The upcoming week may see a relatively quiet period of trade, as event risk will be limited to a second-tier NBNZ Business Confidence Survey.

The New Zealand dollar is likely to trade off of new developments in the global carry trade phenomenon, with the recent rout leaving pairs susceptible to a retrace of extended declines. Though markets are likely to put popular high-yielding pairs through their paces on an unwind of overextended Japanese Yen shorts, looking at the past tells us that the carry trade may nonetheless see a grind higher through the medium term. One only has to look back to the late February/early March carry shakeout to see that pairs like the NZDJPY and AUDJPY rebounded in trading that followed. The Kiwi-Yen pair is currently in the midst of its worst drawdown of the year, but this arguably allows for better entry on longer-term focused carry trade longs. Whether or not such a retrace occurs will largely depend on the performance of global equity markets, but a stabilization in worldwide stock indices may pave the way for a continuation of Japanese Yen declines. The losing yield advantage of the New Zealand dollar perhaps leaves it susceptible to further drawdowns against the Australian dollar, however, as the Aussie looks forward to a near-certain rate increase in the coming August Reserve Bank of Australia meeting.

Boris Schlossberg is a Senior Currency Strategist at FXCM.