Fear Factor! Dollar Rebounds As Risk Reduced
What a difference a week makes. Summer doldrums quickly disappeared as capital markets scrambled wildly to cope with the liquidity crisis unleashed by the BNP Paribas announcement that its was suspending redemptions in its asset backed funds. This was the third such move by a major financial player over the past few weeks, and while in the short term it may have been a prudent course of action for preservation of assets in the fund – the long term implications for capital markets of such arbitrary changes in policy could be disastrous. As one market participant noted in mid-week, “There is huge pressure on money rates due to an apparent sense of mistrust. Following BNP Paribas' statement, very few institutions appear willing to lend. If you kill off the inter-bank market and the asset- backed commercial paper market has effectively collapsed, then we look to be heading for a serious liquidity crunch.'” Indeed if investors lose confidence in their ability to redeem their capital, they will simply refuse to provide it and that could have a chilling effect on all risk taking operations.

As we noted on Thursday, “Ironically enough, this doomsday scenario would likely benefit the US dollar – the epicenter of the sub-prime mess - as the greenback would become bid on safe haven flows. Tonight’s price action is a good example of this dynamic at work, as the buck strengthened across the board following the BNP news.” The safe haven theme may persist next week, especially if the markets continue to experience volatility, but eventually real economic issues will begin to weigh on the greenback. Unlike this week, next week’s calendar is chuck full of data and most estimates look for declines in everything from housing to consumer confidence. One possible boost for dollar bulls could come from the Retail Sales number on Monday. With expectations of a consumer slowdown so prevalent in the markets, any upside surprises in the July data would suggest that the US consumer remains relatively healthy despite the collapse in housing. If that remains the case, talk of a soft landing rather than a hard crash could improve market expectations of US growth going forward.

Euro – Could ECB Hold Off on the Hike?
No done deal yet. While last week the markets priced in with near certainty the possibility of a rate hike to 4.25% from the ECB after Jean Claude Trichet used the keyword “vigilance”, this week such certitude no longer exists. After the BNP turmoil on Thursday, the ECB was forced to inject more than 130 Billion dollars into the system as European credit markets came to a grinding halt. Therefore, it is not unreasonable to speculate that the central bank may decide to hold off tightening monetary conditions given the very precarious nature of money markets in the 13 member region.

Such a move however could have severe repercussions on the euro. The ECB prides itself on transparency and consistency, so a change of policy after essentially telegraphing a commitment to a hike could send the euro reeling not only on interest rate differential reasons, but also because it would suggest far deeper financial problems in the Euro-zone and undermine the case for euro as a viable alternative to the dollar. That is why we believe the possibility of a rate hike delay while real is remote for the time being.

Next week the economic calendar offers little support to euro bulls. German GDP is expected to print lower dropping to 2.8% from 3.1% in Q1. This by the way will be the first time since the summer of 2006 that US GDP growth will exceed that of EZ biggest economic actor and while the overwhelming majority of analysts believe this to be a one off event, it bears watching. If against all market expectations EZ growth dips below US growth in H2 of 2007 the primary source of euro’s strength may be gone.

Japanese Yen Still Ruled By Risk Aversion Trends
Risk aversion trends have kept the Japanese yen relatively strong against the majors, with USD/JPY continuing to follow the movements of US equity markets in lockstep. For example, last Thursday’s plunge in European equities, which was followed by massive losses in US and Asian equities coincided with a 200+ point tumble in USD/JPY down to a low of 117.20. Economic data was generally unsupportive of gains for low-yielding yen, as sentiment amongst households remained weak. In fact, both the Eco Watchers and the Cabinet Office consumer confidence reports showing mounting pessimism, which did not get much help from political conditions, as the Democratic Party of Japan took the majority of the Diet’s Upper House elections from the Liberal Democratic Party. This has created tension as both parties debate whether Prime Minister Shinzo Abe, leader of the LDP, should step down from office. Abe has said that he will do the “responsible thing” and stay on despite DPJ plans to push for dissolution of the Lower House and a new general election that would test the LDP mandate. Nevertheless, as we said last week, “As it stands, there are really only two fundamental events that could perpetuate a strong move by the Japanese yen: a rate hike by the Bank of Japan or a jump in inflation. Until then, the pair will remain at the whim of carry trade flows, so traders should remain alert to the risk aversion trends that have recently contributed to USD/JPY weakness.” This remains the case looking forward, as traders remain spooked by liquidity and credit crunch fears.

Nevertheless, traders should be aware of the Japanese economic data on tap this week, as the results could have an impact on future policy decisions by the BOJ. The Leading Economic Index is anticipated to rebound in the month of June, but the figure tends to be revised frequently, minimizing the impact of this particular indicator. Machine orders are estimated to show a drop in demand, signaling that business investment continues to slow. This was made evident in recent GDP reports, though the slack in capital expenditures was made up by consumption, which isn’t entirely surprising given the tight conditions of the labor market. Regardless, this pick up in spending has yet to filter into price growth, leaving prospects for further rate normalization very low. However, with the recent political turmoil created by the DPJ’s win for the majority of the Upper House possibly distracting the LDP from the central bank’s policy actions, there is the potential for a hike by the BOJ in September.

British Pound Sets Sights On 2.00 As BOE Hawks Fade
The British pound ended the week lower despite consistently hawkish commentary by the Bank of England. Last Wednesday, the central bank issued their Quarterly Inflation Report and said that the inflation rate will likely stay above the 2 percent target until 2009, assuming that the bank hiked rates by 25 basis points to 6.00 percent by the first quarter of 2007. The statement effectively assured the markets that the benchmark rate would be lifted in the near-term, and while the news did lend GBP/USD a temporary boost of nearly 60 points to test the 2.0400 level, a bout of US dollar strength kept Cable gains in check. Meanwhile, the UK's physical trade deficit narrowed to the best level since April of 2006 thanks to record fuel exports. Most other raw material groups either held steady or increased the burden on the country's balance sheet, but shipments of finished goods to Europe and Asia more than made up for this as economic growth in those regions continues to pick up the slack of a slowdown in demand from the US.

Looking ahead to next week, the British pound faces heavy event risk with inflation data, labor market reports, retail sales, and the minutes of the most recent BOE meeting are all due to be released. CPI will be the first major hurdle, and with price growth expected to have eased during the month of July, the news could prove to be highly bearish for the British pound. However, if the figure is released at a higher-than-expected rate – even if it still reflects a slowdown – Cable could surge. Next up, the BOE minutes and jobless claims report will hit the news wires at the same time, and the spotlight will likely turn to the central bank. If the minutes reflect any votes for hike, markets may consider the possibility of a rate increase next month, especially in light of the BOE’s Quarterly Inflation Report. Nevertheless, given the bank’s aggressive policy tightening over the past year, the MPC will likely want to wait until later in the year to allow more time for their past actions to take effect. As a result, risks are tilted to the downside for GBP/USD this week.

Can Swissie Garner Strength Despite Slowing Spending?
Two weeks ago we said, “In the scheme of things, the franc is the FX traders’ second favorite funding currency (behind the Japanese yen). This gives the unit a unique sensitivity to big swings in risk aversion and appetite that cross asset boarders.” While we didn’t see USD/CHF follow USD/JPY in lockstep, the Swiss franc did lose steam like the Japanese yen, but proved to be less sensitive to carry trade swings as risk aversion prevailed over the markets. Economic data out of Switzerland did not help the case of the Swiss franc either, as the SECO consumer climate index surprisingly plunged to a reading of 15 against estimates of an improvement to 22 from 20. The drop is someone disconcerting, as resilient consumption growth has led to “goldilocks” economic conditions in Switzerland. A breakdown of the data shows that the biggest decline was seen in the 12 month outlook for the economic climate, which declined to 22 in June from 31 in June, while the consumer’s ability to save declined to 35 from 44 for the same periods. It appears that consumers are starting to feel somewhat jittery as concerns build that a slowdown in the US will spread into other regions. Nevertheless, with the unemployment rate at a nearly five-year low, Switzerland is unlikely to see a sharp decline in domestic spending in the near-term.

Economic data out of Switzerland tends to be thin, and this week is no exception. First, despite a drop in the SECO consumer climate index, the Swiss consumer will likely remain resilient, which should be reflected in the retail sales report on August 15th. However, given the volatility of this particular indicator, traders don’t usually take swings higher or lower very seriously. As a result, risk aversion trends will likely remain the main driver of Swiss franc price action, creating downside risks for USD/CHF this week.

Can The Canadian Dollar Hold Its Highs Though Market Tumult?
While the FX market has been jolted this past week by the unwinding of the overextended carry trade and a general flight from risk, it seems that USD/CAD has sustained only minor damage through the first wave. Though the 1.05 to 1.06 range that was so neatly tracked out in the first half of the week was breached, the moves outside these boundaries measured up to little more than false breaks. More important to price action seemed to be the housing and employment data coming off the economic calendar and the direction of key commodities. In the past week, gold and crude oil prices have fallen well off their highs as both alternative assets were caught up in the wave of risk aversion. However, whereas the commodity market was once again having a general effect on the currency market, the influence of the data was much easier to follow. The economic calendar withheld its impact on the market until late in the week. Thursday’s housing data clearly had the greater sway over the traders, though the numbers turned few heads as they did not set any records. Printing first, July housing starts fell 4.3 percent to 215,600 units on an annual basis. While this number was short of the 223,500 consensus and a four-month low itself, it holds few implications for growth projections or speculation surrounding the timing of the next shift in interest rates. Similarly, the New Housing Price Index for June gave little to go on. A 0.7 percent rise in home prices for the month was a modest miss of the market consensus and certainly a deceleration from the nine-month high 1.1 percent figure from May. Regardless of the seeming minor implications these indicators held, USD/CAD nonetheless rallied 100 points before fully retracing the move. In comparison, the following day’s employment data proved to be an utter non event. Free from the cross effects of the US NFPs, a disappointing employment change and drop to a new 33-year low in the jobless rate promised action. Alas, USD/CAD volatility held steady and no direction was found.

Though USD/CAD has weathered the credit storm thus far, traders should not stop looking for its effects in the exchange rate. Though the US and Canadian economies are closely tied and their interest rate spread is relatively tight, it can still come under the umbrella of risk aversion. With many of the other pairs at multi-decade highs selling off, it doesn’t take too much of a stretch of the imagination to see a bigger rebound for the oversold USD/CAD coming to pass. However, while the masses decide whether or not to liquidate their long loonie positions, the calendar should keep event-risk traders busy. First up will be the trade balance report for June. The market’s official consensus is calling for a modest dip in the surplus to C$5.5 billion. The actual outcome will likely depend on the trade off of week US demand and strong commodity prices through the period. The rest of the event risk on deck is second tier. Manufacturing shipments may have already been tipped off by the Ivey PMI report. International securities transactions will not likely generate much interest even in this time of risk aversion. Finally, wholesales sales will be primarily useful in setting up the following week’s retail report.

Australian Dollar Roiled By Credit Fears, Waits For RBA To Speak
As expected, the Australian dollar was in for choppy seas last week; though the fundamental basis for these moves was not what we expected they would be going into the period. Going back in time, the economic calendar read like a mine field for event-driven trading. The data run kicked off in earnest with Wednesday morning’s RBA rate decision. The central bank delivered what hawks had wanted: a quarter point hike that brought the overnight cash rate to an 11-year high 6.50 percent. However, the reaction to the announcement was certainly not what would be expected of rates at such levels. AUD/USD began a gradual advance that would extend hold for a little over a full day; a sharp rally would never come to pass. The dampened reaction to the announcement was likely due to a combination of factors. For one, PM John Howard quickly came out after the hike to say that further tightening would hurt home owners. When Howard won the top office back in 1996, he promised that mortgage rates would never be as high as they were when Labor was in control while he was at the helm. They are there now. RBA Governor Stevens will undoubtedly feel the pressure from the PM’s office to hold off on any more hikes until after the general election that must be held at latest by the end of January. What’s more, the statement that accompanied the decision was conspicuously tailored to those trends leading into this hike with no outlook for inflation or growth in the months ahead.

Looking at the docket for the week ahead, the RBA’s rate hike may get a second wind. The policy group was almost certainly mum on their forecasts for growth and inflation so that they could deliver it properly in their quarterly Monetary Policy Statement due Monday morning in Sydney. Market participants will scour the text looking for any key words that could signal if there is another 25 basis point boost is in the pipeline and when it may come. However, given current market conditions, it is likely that the central bankers are making some last minute revisions. The Australian dollar was swept up last week in a global credit crunch that sent equity benchmarks, government bond yields and carry trades diving. The fire sale of everything overbought, overleveraged and related in the most tangential way to US subprime mortgages sent AUD/USD into a 250-plus point nose dive that came in one 24-hour burst. Seeing as how this broad market downturn was triggered by only one bank’s freeze on withdrawals from its hedge fund, it isn’t hard to imagine that another round could be set off by another non-US bank citing problems tied to the credit market (or worse, the collapse of a major firm). While traders walk on eggshells waiting for the next bout of credit-driven volatility, they should remain relatively entertained by the few indicators scheduled for release. Sentiment will be well covered with a NAB Business survey for July and Westpac Consumer gauge for August. Though it is the wage cost index for the second quarter which has greater implications for spending and inflation latter and perhaps a rate hike.

Can Data Save The Kiwi, Or Is The Carry Current Too Strong?
Like the Australian dollar, the New Zealand currency actually started last week out on a strong footing. For the first few days, there was little data coming off the economic docket - allowing the kiwi to hold a steady range against its benchmark counterpart, the US dollar. The only indicator to create waves initially was Monday’s Labor Cost Index for the second quarter. The official consensus was already forecasting a rebound in the private wages report; and yet the pick up proved larger than the market had for allowed. However, the 0.8 percent increase in wages and compensation was little surprise given the related data recorded over the quarter. For the market, the indicator’s support of holding up a modest hawkish bias for the RBNZ was worth a turn out of a quick sell off that was triggered a few hours before the data crossed the wires. After this report, it looked as if traders were happy to spend the remainder of the week range trading between 0.77 and 0.7550 - though with savvy traders obviously keeping their eyes on the employment data for a possible fundamentally-triggered move. When the second quarter unemployment gauge reported a new record low 3.6 percent with spot just below resistance, it seemed a formality to wait for the breakout. This move never came to pass though as grumblings of a large European bank having trouble with its hedge funds sparked a quick increase in corporate credit spreads that led to a sell off in equities, both government and corporate debt yields and eventually carry trade pairs.

The kiwi’s future is murky at best for the coming week. There are a number of market-moving indicators scheduled for release over the coming days; but if traders in every market are concentrating on keeping liquid, the influence of the fundamental reports may be negligible. Presumably, it will not be very hard to keep track of fear in the credit market. Recently, yields, equities and carry trades have held a very high correlation to concerns over risk and the access to liquidity. This will likely only intensify over the coming week. If investors deem the sell off overblown, then the kiwi can find a bid on the cheap. On the other hand, if the credit scare has upset something far more pervasive in terms of fear, the kiwi could a further retracement that carves out another few hundred points. On the other hand, should the risk correlation weaken, the New Zealand calendar may have its chance to guide the currency. Tuesday’s retail sales figures represent the fundamental trader’s best chance at a trade. Since the data covers June, there will be a quarterly number that will only intensify the action. Expectations are running low for both, but it is the consensus for no change over the quarter that should really capture the market’s interest. Later in the week, the ANZ Business PMI reading for July will give an indication of what conditions were like for the corporate sector before the credit crunch took hold. Also from the business side will be the quarterly producer prices figure numbers, though a measure of inflation in the pipeline may be too little to late given the RBNZ’s comments recently and the efforts to inject liquidity into the market.

Boris Schlossberg is a Senior Currency Strategist at FXCM.