Dollar Rally Done As Fed Yields to Pressure?
On Friday just before the opening US stock market trading the Fed announced a 50 basis point cut in the discount rate. The discount rate is the rate Fed charges to other banks and is nearly always higher than the far better known Fed funds rate which is the rate banks charge each other for overnight loans. In reality the move was more symbolic than meaningful. The discount rate accounts for a miniscule amount of loan business. For example discount lending averaged just $11 million in the week ended Aug. 15 paling in comparison with billions of dollars that the Fed injected into banking system through its open market operations. Nevertheless, stocks bounced on a much needed relief rally with Dow ending above the 13K for the week.

The move produced a change in the trend that dominated the currency market the whole week. As we wrote on Thursday, “The dollar now finds itself in a bifurcated market – weaker against the yen but stronger against all other G-10 currencies. It has become the primary beneficiary of the carry trade unwind as currency traders sell the high yielder’s and park their assets in dollars for the time being.” By Friday however those trades began to reverse as EURUSD rallied by more than 100 points from its weekly lows as risk appetite returned.

Does the discount rate cut presage a cut in the Fed funds rate? All signs point that way especially if US economic growth slows significantly in the next several weeks. Ironically enough, past week’s data on the Trade Balance should result in an upward revision on GDP growth putting further distance between US and EZ Q2 GDP figures. But the markets are unlikely to pay much attention to past performance. Far more significant will be the Durable Goods data due on Friday. If US consumers are indeed starting to retrench the long term impact on the dollar is likely to be negative as traders will begin to price in the risk of recession.

Euro – At the Whim of EUR/JPY
The flows in EURUSD this week were driven almost exclusively by the price action in EURJPY – which has become the proxy for risk appetite in financial markets. As risk aversion took hold EURJPY plummeted taking euro down with it and as the fear eased EURUSD rallied. For the week the pair saw a rather wide 350 point range but it was tame in comparison to the more than 1200 point range in EURJPY. As the week came to a close the sharp declines in EURJPY no longer precipitated very strong sell-off in the EURUSD. The unit was still vulnerable to carry trade liquidation factors but as the price declined it found more and more bids as traders perceived value at those levels.

On the economic front the news was unsupportive of the euro. EZ GDP missed expectations, printing at 2.6% vs. 2.8% forecast. As we noted on Tuesday” this is the first time since Q1 of 2006 that EZ GDP has been weaker than US GDP. While one quarter does not make a trend, this dynamic bears careful watching. The rally in the EURUSD over the past year has coincided with the outperformance of the region’s GDP versus that of the US. If that dynamic has now changed and EZ GDP will begin to lag US GDP growth the euro could weaken further as we the second half of the year progresses.”

Next week the market will get a look at the Industrial Production report as well as both Manufacturing and Services PMI. If the data shows further deterioration in the region the case for an ECB rate hike in September will grow weaker and weaker. Although the ECB prides itself on consistency and transparency it may have to hold off any plans at tightening given the turmoil in the markets and the surprising deceleration of growth.

Japanese Yen Remains Reliant On Risk Aversion
The Japanese Yen proved to be unstoppable last week, as a lingering liquidity crunch drove equity markets lower and led carry trades to unwind further. In fact, the oft-beleaguered, low-yielding currency jumped 3.8 percent against the US dollar, more than 5 percent against both the Euro and British pound, and a whopping 11.2 percent against the New Zealand dollar. This dramatic price action only highlights the fact that Japanese fundamentals are playing absolutely no role whatsoever into buying and selling of the yen. Case in point: GDP slowed dramatically in the second quarter, easing to a tepid 0.1 percent pace from the first quarter, while the annualized rate plummeted to 0.5 percent from a downwardly revised 3.2 percent. A breakdown of the data shows that capital investment in the private sector expanded, but consumption was down and exports failed to grow as US demand fell, curbing the Japanese economy's growth. It appears that when the US sneezes, much of the world still catches the flu, and given the deteriorating economic conditions we’ve seen develop over the past week, the prognosis may get worse in Japan.

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 – neither of which we’ll see this week. The central bank is scheduled to meet and announce their rate decision on August 22nd, and while there is no specific time available, it tends to be released around 23:50 EST. Globally, rate hike speculation has been curbed dramatically, and Japan is no exception. Despite the fact that fixed income markets had previously been pricing in a rate increase by the Bank of Japan, we saw little economic support for a return to rate normalization given softness in consumption growth and continued deflationary conditions. As we mentioned above, economic conditions in the US and Japan appear to be worsening, which severely limits the ability of the central bank to take any monetary policy tightening measures. As a result, USD/JPY will remain at the whim of carry trade flows, so traders should remain alert to the risk aversion trends that have recently contributed to weakness in the pair.

British Pound Hammered By Risk Flows, Data And Rate Outlook
Though the pound sterling’s loses last week were far from those recorded by the Australian and New Zealand dollars, they may have been fatal to the currencies long-term bullish trend. For once, the market had an overabundance of ‘reason’ for the pound’s drop. Looking first to the tidy economic calendar, there were a number of indicators contributing to the recent, aggressive price action. There were two arteries of fundamental data through the pair: inflation and the consumer. Each had promising components, but both were ultimately detrimental to the pound. For the consumer sector, retail sales were the silver lining. A 0.7 percent increase through the month of July far outpaced expectations and marked a five month high. What’s more, a modest drop in jobless claim benefits helped push the claimant rate to a more than two year low. However, a plateau in both spending and hiring may have been signaled by a big turn in wage growth. Average earnings grew 3.3 percent through June, the slowest pace since June 2003. The inflation data had fewer bright spots. Consumer inflation dropped the most in five years in July as a 1.9 percent print for the headline read slipped below the BoE’s target rate. The core figure followed suit in a big drop from 2.0 percent to 1.7 percent. The inflation data will be integral going forward as it gives the central bank a solid foundation to respond to the recent credit and liquidity woes in London’s capital market. Even before this data was fully absorbed, the minutes from the central bank’s August monetary policy gathering had already revealed a 9-0 vote against further hikes with comments that were sounding increasingly like those that would be made by doves.

Looking at the week ahead, the true risks to direction and volatility will likely not be easily divined. The economic calendar will struggle to play a major role in price action. After last week’s spending, employment, wage and inflation data, there are few market movers left in the fundamental confers. However, considering current market conditions, a few low key indicators may actually have outsized effects on the pound this time around. As speculators calculate the probabilities of if/when the central bank will genuinely entertain a possible rate cut, the Rightmove housing price index and the M4 money supply numbers will give objective numbers to work with. The final reading on second quarter GDP is forecasted to pass its mark unchanged, but a revision could generate considerable buzz. A downgrade would add to concerns that have already been raised through the drop in earnings and inflation. On the other hand, a pickup like the one expected for the US growth report could dampen irrational fears that the pound is falling apart. However, when everything is said and done, the true fuel for price action will likely remain the global flight to quality and fears that US credit problems will fully entrench themselves in the UK.

Will The Carry Trade Unwind Work Against Swissie?
As a low-yielding currency, we previously saw price action in the Swiss franc follow the Japanese yen. However, the correlation diverged last week as USD/CHF rose 0.65 percent while USD/JPY fell 3.81 percent, as US dollar strength against everything but the Japanese yen dominated the forex markets. Looking at the crosses, Swissie fared a bit better gaining 0.94 percent against the Euro and 1.46 percent against the British pound. Economic data out of Switzerland did not help the case of the Swiss franc either, as retail sales slowed dramatically to an annualized rate of 1.0 percent from 7.2 percent. The drop is someone disconcerting, as resilient consumption growth has led to “goldilocks” economic conditions in Switzerland. Furthermore, this follows a similar drop in the SECO consumer climate report, and 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, producer and import price growth is expected to pick up 0.3 percent, however, the data’s impact on the Swiss franc may be limited as inflation remains very tame. Furthermore, given the instability of the financial markets, most central banks – including the Swiss National Bank – are no longer anticipated to raise rates. As a result, USD/CHF trade will likely remain dependent upon price action for the greenback, and with risk aversion still the main theme for the forex markets, the pair may target 1.2200 once again.

Canadian Dollar Loses Traction on Carry Shakeout
The Canadian dollar finished lower for the first week in four, as a sharp carry trade unwind sent the currency significantly worse against the Japanese Yen. The CADJPY posted its worst single-week decline in nearly a decade before a later carry trade bounce eased losses. A simultaneous flight to safety to its US namesake pushed the USDCAD to fresh two-month highs, leaving momentum clearly to the upside through short term trade. Domestic economic data only further fueled Loonie drops, with International Trade and Securities Transactions coming in below consensus forecasts. Domestic Manufacturing likewise showed signs of continued skids; Shipments lost a whopping 1.8 percent through the month of July. As the most trade-dependent country of the G-8, Canada’s economic growth will sorely depend on a rebound in key trade figures. Such dismal performances have subsequently dimmed prospects on GDP expansion rates, and with them forecasts of higher Canadian interest rates through year end. In fact, the Loonie yield curve has now priced in an approximate 50 percent chance of a rate cut by December. Such developments certainly leave a bearish tone on Canadian dollar trade, but the upcoming week of inflation data may force markets to reassess forecasts on domestic yields.

Tuesday’s Consumer Price Index and Retail Sales reports may potentially shift expectations for Canadian interest rates and subsequently force large moves in the domestic currency. The Bank of Canada Core Consumer Price Index rate is forecast to come in at 2.3 percent on a year-over-year basis, above BoC targets of 2 percent but down from June’s 2.5 percent result. Such signs of moderating price pressures will easily be enough to keep a lid on rate hike expectations, leaving the Loonie to falter against its US namesake. It will conversely take a strongly positive surprise to lift market yields above an astonishingly low 4.27 percent on the December contract. A later Retail Sales Report is likewise unlikely to spark a jump in yields, with a disappointment in recent Wholesale Sales figures predicting the same through Tuesday’s report. Consensus forecasts call for a 0.5 percent drop through July, but retail turnover may drop further following a 2.8 percent surge in June. This will do little to help the Loonie’s cause, leaving risks to the downside for the currency through the coming week of trade.

Australian Dollar Plummets, RBA Puts Reserves Into Action
The Australian dollar was one of the top movers this past week. Unfortunately, for those that were trying to catch a bottom, the pain probably seemed endless since AUDUSD traced out its biggest weekly drop since 1983. Realistically, the economic calendar had little hand in all the price action, though there were a number of releases that could shape growth trends and the RBA’s policy outlook in the months ahead. Inflation projections received a boost from a the quarterly wage growth report. Earnings ramped up to its fastest pace of growth since the first quarter of 2005 in the second quarter. Another strut for the economy came from the NAB business sentiment survey through July. Australian firms reported record profits and sales for the month that in turn lifted the current conditions report to its highest level in the indicator’s short 10-year history. However, even this indicator had its downside as the outlook turned decidedly sour with concerns raised over the effect of higher interest rates on profit. Consumers were worried about the same thing. The biggest drop in optimism in nine months was clearly a sign of discomfort with lending rates an 11-year high and massive losses to investment portfolios as the equity market plunges.

Though the aforementioned indicators were fundamentally important to the Australian economy and currency, the real impetus for price action was found elsewhere – namely global credit and equity markets. Initially, policy officials the world over repeatedly reassured the markets that the growing subprime issue in the US would be contained to its boarders. However, after a number of international banks and hedge funds reported problems (including Australia’s own Macquarie and Basis Capital), fear swept the globe like wild fire. For Australia, the panic was reflected in the Australian dollar, bonds and equities. The nation’s benchmark S&P/ASX 200 closed last week down 12 percent from highs set just a few weeks ago. Through all of this, the central bank tried more than once to pull the Aussie dollar out of its nosedive. Following up on previous week’s rate hike, Governor Glenn Stevens released a quarterly monetary policy report that dripped with hawkish rhetoric. Key from the report was the upgrade in inflation expectations such that a hike seemed almost inevitable by early next year. Despite the report though, and Stevens active echo at his Parliamentary testimony later in the week, the Aussie dollar didn’t respond. When all else failed, the governor decided to use the central bank’s reserves to prop the currency; yet even that failed to charge bulls.

In the days ahead, exogenous factors will likely steer the Australian dollar once again as there is no top tier indicators scheduled for release. Should risk aversion continue to drive down the currency, Governor Stevens will likely try to encourage the market through verbal reassurances and perhaps another round of intervention. However, the RBA’s reserves are relatively small and their efforts may ultimately have the same lack of effect that the RBNZ’s did a few weeks ago. Another problem may grow out of China’s markets. With investors pulling capital out of emerging markets, the giant’s engine of growth may stutter and demand for Australia’s raw materials in turn will cool.

Carry Trade Decimates the Kiwi, Can it Come Back?
The New Zealand dollar posted incredible losses against major trading counterparts, with a well-publicized carry trade rout dooming the currency to continued tumbles. The now-infamous strategy recently saw its second-largest drawdown since the inception of the Euro. A portfolio that remained long the three highest-yielding major currencies and short the 3 lowest-yielders lost an unleveraged 10.3 percent from late July highs. This is second only to the 10.8 percent drawdown seen in 2006, but the severity of the most recent occurrence underlines the level of fear across financial asset classes. Whether or not carry can make a comeback remains the critical question in outlook for the Kiwi, as recent economic data has likewise left a bearish tone on price action. Retail sales disappointed strongly to the downside, signaling that fast-growing consumption in the small Asia-Pacific may slow from its previously impressive pace. This in and of itself would give signs to the Reserve Bank of New Zealand that its monetary policy tightening has begun to take effect. Given that the kiwi has primarily found strength on expectations of further interest rate hikes, lower consumption and inflation rates would only add further downward pressure on NZD pairs.

Upcoming event risk will be relatively sparse in the New Zealand economy, but Thursday’s Trade balance report threatens volatility on any surprises in the data. Though there is yet to be an official consensus forecast for the report, it remains safe to say that analysts expect new Zealand trade deficit to remain relatively unchanged. An exceedingly high exchange rate hurts the competitiveness of Kiwi exports abroad, while strong domestic consumption has made imports surge to record-highs. The recent tumble in the domestic currency will only exacerbate such trends through the short term, but may lead to a longer-term improvements in net exports for the Kiwi economy. Markets speculate that the impending surge in import prices may force the Reserve Bank of New Zealand to raise interest rates to contain inflationary pressures. This could potentially lend a bid to the downtrodden NZD currency pairs, but such an outlook will greatly depend on the performance of the global carry trade through the same period. Given such an extended carry unwind through recent weeks, it may be only a matter of time before we see the strategy slowly regain ground.

Boris Schlossberg is a Senior Currency Strategist at FXCM.