Dollar – Change of Story?
Will he or won’t he? That was the question the whole week long in the currency market as traders wondered if Fed Chairman Ben Bernanke would give in to pressure and signal a rate cut at the upcoming FOMC meeting on September 18th. On what would usually have been a sleepy, pre-holiday Friday, markets were jumpy as Dr. Bernanke offered his remarks at the Jackson Hole symposium. In the end the Fed chief acknowledged that the sub-prime problem has started to affect the general economy, stating that the Fed, “will act as needed to limit the adverse effects on the broader economy that may arise from the disruptions in financial markets."

Although the Chairman left open the possibility of keeping rates unchanged, the markets took his remarks to mean that the Fed will indeed cut come September. Stocks rallied and paradoxically enough so did the dollar against the yen. Why did the dollar gain on the yen despite a possible compression in rate differentials? Because the carry trade is far more influenced by the action in the stocks and the hint of a cut was boon for equities which rallied for more than 100 points on Friday. Against the euro the buck was actually a bit stronger as commentary by Jean- Claude Trichet suggested that the ECB may hold off on rate hikes next week.

The rate cut issue may be settled once and for all after Non-Farm Payrolls next week. If the employment data once again produces the second sub-100K job performance in a row, the rate cut will be almost assured. Despite the soothing rhetoric, a weak July NFP would indicate that the economy was already slowing before the sub-prime mess became front page news, and the markets will demand action from monetary authorities. Should that occur the greenback will likely weaken against the euro and the other high yielders as markets will begin to price in possibility of a change in policy towards a new loosening cycle.

Euro – Trichet Signals Pause
The euro was uncharacteristically quiet this week, failing numerous times at the 1.3680 level as Jean Claude Trichet’s remarks at the start of the week hung over the unit like a dark cloud. President Trichet did not reiterate his call for vigilance and furthermore noted that "What I said on August 2 was before the market turbulence." The speech in Budapest indicated that the ECB chief may be looking for a graceful way to reverse his initial guidance to hike rates at the September 6th meeting.

There is perhaps still a chance that the ECB will follow through on a rate hike, but the odds are slim given the slowdown in economic data from the 13 member region. As we noted on Thursday, “There is good reason to believe that the ECB may remain stationary in September. It appears as though EZ growth may have peaked earlier in the year as today’s eco data showed that German unemployment rolls were reduced by smaller than expected –15K. Conditions in the 13 member region remain expansionary but with growth decelerating the ECB may feel pressure to maintain a neutral monetary policy until it sees stronger signs of a pick up in demand.”

Next week the rate decision on Thursday will be the key event of the week for the Euro-zone. If the ECB remains stationary but signals that this is a pause rather than a complete stop, the unit should be too harshly impacted. However, if European monetary authorities suggest that the policy is no longer restrictive, the euro could see some significant selling especially on the crosses against the pound and the Swissie.

Japanese Yen Likely to Decline as BOJ Still Grapples with Deflation
The Japanese yen continued to move with the ebb and flow of equity markets, as a surge in risk aversion early in the week sent carry trades plunging before renewed market optimism reversed the sentiment. Economic data out of Japan was broadly mixed, as Tokyo CPI was slightly stronger than expected, but showed that the Bank of Japan is still grappling with deflation. The jobless rate was also encouraging at a nine-year low of 3.6 percent, however, tight labor markets have yet to give consumers enough spending power to boost purchases. We saw this feed into the July retail sales report, which plummeted 2.4 percent and was exacerbated by the combination of an earthquake, a typhoon and higher taxes.

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. 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. Capital spending is anticipated to remain strong, but show a slowdown from the quarter prior, while wage growth is predicted to soften further, which will not bode well for consumer spending. With two drivers of economic growth – business investment and consumption – showing diminishing power, the picture does not look good for Japan. Regardless, USD/JPY price action will likely remain contingent upon risk aversion trends, and now that Fed Chairman Ben Bernanke has somewhat assured investors that he will support the markets in times of distress, carry trades and equities could resume their gains next week, with a break above trendline resistance at 116.93 targeting 119.34.

British Pound Tests 2.02 with Rate Decisions on the Horizon
The UK economic calendar was inordinately quiet last week, and the range-bound, choppy price action through most of the period stands as testament of lull. Even the majority of the low level indicators were held back until Thursday. Among the wave of lower tier reports was the Nationwide Building Societies’ housing price index report for August. In contrast to the Rightmove report released from the previous week, the Nationwide index cooled to a five-month low 9.6 percent in August. While this may seem like an inconsequential report, the same was said about the US housing market before a crack in the subprime lending sector laid bare a much larger, underlying problem. This UK housing sector may follow a similar path. It is hard to argue against suggestions that the UK housing is over extended. London has consistently been among the top three most expensive cities in which to live for years, the Bank of England has increased the nation’s overnight lending rate to a six-year high 5.75 percent and British consumer debt is reaching a record – well beyond 1 trillion pounds. These are volatile ingredients that may prove flammable if defaults rise. The only other market-moving report for the week was GfK’s consumer sentiment survey for August. Despite the clamor in financial markets and the threat of another rate hike, confidence still improved last month. While this could give the BoE something to think about for the future, it most likely won’t alter the course of monetary policy.

For the days ahead, another round of second tier economic indicators will present minor event risk. The HBOS Housing Price index will offer the a third view of activity in the residential market through August; though barring any incredible divergence from the previously released reports, it will not likely generate much in the way of price action. Two indicators that may provide more of a tangible response from the pound are the Nationwide Consumer Confidence survey and Industrial Production figures. After the GfK’s upside surprise, market participants will be looking for some consistency from the Nationwide report to garner a true interest in consumer sentiment, rather than just waiting and taking a cue from lagging spending reports. The July factory output report will work off of the pickup in production reported in the second quarter GDP breakdown. In the grand scheme of things, all of these indicators will merely cloud the air before the pivotal BoE and ECB rate decisions due Thursday. The Monetary Policy Committee is expected to leave the overnight lending rate unchanged at 5.75 percent as they wait to assess the damage from the recent credit market freeze through objective economic data. However, the BoE has not been as vocal as some other central banks, so any word to clear the air will be valuable. And, though its policy decisions will have no direct effect on the pound and UK economy, the ECB’s rate decision could have an impact on the sterling. With growth and monetary policy closely linked around the globe, a falter from the ECB may call an end to the worldwide hawkish bias and once again raise issues of risk.

Swiss Franc Falls Back as CPI Limits SNB Hike Possibilities
The Swiss franc ended last week lower on the combination of risk seeking and tepid inflation figures, as the Swiss National Bank’s widely expected rate hike in September may now be in danger. CPI data was markedly lower than expectations at a very meager 0.4% annual rate. The news provided fuel for franc doves who have argued that the SNB may choose to keep rates on hold given the absence of any headline pricing pressure in the system. Meanwhile, the EUR/CHF cross has gained ground on further carry trade flows, and as Senior Currency Strategist Boris Schlossberg said last week, “we believe any upside potential may be limited as the SNB remains concerned about the weakness of the currency and may tighten rates despite the lack of any signs of inflation if the franc sees additional declines against the euro.” This is mainly due to concerns of import price inflation, as the Euro-zone is Switzerland’s biggest trade partner.

This week, USD/CHF will likely turn to US data and dollar flows for directionality, as Swiss economic data tends to only have a short-term effect on the national currency. Nevertheless, it will be worth looking at the SVME PMI and GDP releases, as they may be of importance to the SNB when they meet on September 13th. SVME PMI is anticipated to ease back slightly, but with estimates at a robust 61.5, it is clear that the Swiss economy remains one of the healthiest and most stable in the developed world. The second reading of Q2 GDP should echo this statement, with expansion anticipated to show a brisk 2.4 percent annualized pace – up from 2.2 percent in the first quarter. Regardless, with hefty resistance holding up just below the 1.2100 level, we could see USD/CHF start to decline towards the early August lows of 1.1819 once again.

Canadian Economic Outlook Unclear, Loonie Remains Uncertain
The Canadian dollar remained largely unchanged against its US namesake, as an early-week tumble gave way to later appreciation on strong economic data. Indeed, Friday’s second quarter GDP report showed that the North American economy grew at a stronger than expected 3.4 percent annualized pace through Q2, 2007. This was slightly below Q1’s impressive 3.9 percent pace, but matched the highs seen in 2006. Such unexpectedly bullish news gave a lift to the Loonie and left scope for healthy expansion through year end. The bulk of growth came from Personal Consumer Expenditures, which grew at a 2.7 percent annualized rate through the period. Given that the Canadian economy is well-known for being highly dependent on US economic expansion, such signs of a robust domestic expansion rate leave hope that the country may withstand a slowdown in the world’s largest economy. Of course, markets will watch future fundamental data to judge the likelihood of a continuation in such a trend, but recent signs suggest that Canada remains on strong footing despite pessimistic outlook on the US economy.

The coming week is packed with key economic event risk, with Wednesday’s Bank of Canada Interest Rate Decision and Friday’s Employment report to drive volatility across CAD pairs. The central bank is very widely expected to leave rates unchanged through its September meeting; despite earlier forecasts of rising Canadian interest rates, markets now predict that rates may actually be cut through year-end. Such an outlook has undoubtedly weighed on the Loonie, but a hawkish Bank of Canada statement could easily reverse rate-linked Loonie declines. As such, it will be particularly important to listen to BoC Governor David Dodge as it relates to his stance on inflation. If the Governor indicates that inflation—and not growth—remains the main policy concern, the Canadian dollar will almost certainly rally in the wake of such rhetoric. Otherwise, a neutral stance is likely to leave the currency unchanged, while overt dovishness can only force sell-offs in the Canadian dollar.

Later employment data will likewise take on a significant role in interest rate and growth expectations, leading to strong volatility across all Loonie currency pairs. Consensus forecasts show that the economy likely added 16,500 jobs through the month of August, but the Unemployment Rate may edge higher to 6.1 percent on increased participation rates in the broader labor force. Such a result would easily prove bullish for the broader economy, as it would keep the jobless rate at a mere 0.1 percentage point above recent 30+ year lows. Given such strength in employment, it would be difficult for the Bank of Canada to cut interest rates if consumer spending remains strong. Fundamentals behind the Canadian dollar remain unclear—leaving uncertainty to guide future Loonie price action.

RBA Rate Decision and GDP Will Keep the Australian Dollar On Edge
Last week was a busy one for the Australian dollar in terms of economic activity. A number of quarterly reports were sprinkled among some of the top market-moving monthly releases. The data flow began early in the week with the second quarter construction report which unexpectedly dropped 1.9 percent against forecasts calling for a 2.0 percent increase. Ultimately, the report did not stir as much bearish momentum as it could have since the entire drop in construction was seen in the public sector, while ground breaking on private property actually rose slightly. Along a similar thread, private capital expenditure through the same period jumped 6.3 percent, more than tripling the consensus forecast. Of the three quarterly reports that came out over the week, though, the gauge with the heaviest fundamental impact was the current account balance. The broadest measure of trade widened to A$16 billion, the widest deficit on record, as key exports like meat, metals and coal dropped due to extraordinary circumstances like droughts and storms. When these numbers cleared, the monthly data had its go at pushing the market. The retail sales and trade balance figures were both adding to a bullish tailwind. Consumer spending over the period boosted receipts 0.9 percent, a strong complement to June’s 1.6 percent increase and the strongest back-to-back performance in years. More significant was the physical trade report, which confirmed the quarterly current account balance is likely the product of unusual factors. The deficit narrowed more than expected to A$756 million, the highest read in 11-months, as demand for commodity exports pushed total shipments abroad higher by 2 percent.

Typically, when the Australian economic calendar closes out a week packed with data, the following one is barren. This is not the case for the opening days of September. In fact, the indicators on deck have greater fundamental potential than all of the data from last week. The newswires will open up with the typical fare, TD Securities monthly inflation report. There are no expectations, and alone the report wouldn’t generate much enthusiasm from Aussie dollar traders; however, with an RBA rate decision due two days later, it will certainly tout an air of importance. The central bank is not expected to change the nation’s overnight lending rate; though this is not the true value of the gathering. The RBA’s decision is among four central bank meetings this week; and consistency between the outcomes and rhetoric may offer a clue to the global bias towards interest rate policy. Even where the rate decision is taken out of the equation, next week’s calendar is still fully stocked. Second quarter corporate profit will give another sector reading to back up construction and private investment; but it may ultimately be a formality with the GDP report due a short time later. Growth is expected to cool through the period, but this could be chalked up to exogenous factors like those recorded in trade. Finally, taking a page from the US calendar’s playbook, the August employment data will wrap things up. The market is calling for another modest increase that would mark the 10th consecutive monthly increase in jobs.

New Zealand Dollar Downtrend Remains Intact
The New Zealand dollar shed almost all of its previous rebound, as a sharp return to risk aversion hurt the high-yielding carry trade favorite. Largely disappointing economic data did little to ease a fear-led sell-off in the former high-flyer, with the prospects for further rebounds waning through the short term. In fact, the NZD/USD continued its descent into late Friday trade despite a sharp bounce in US equity markets. The currency pair holds a strong correlation to the Dow Jones Industrial Average, but its divergence from the equity index highlights the fact that speculators are uneasy about the currency’s prospects. An earlier Building Permits report certainly did little to assuage fears over a New Zealand economic slowdown, as permits for new dwellings construction fell by the most since April, 2005. The domestic real estate market has been one of the main drivers behind New Zealand’s strong consumer spending-led growth, but a slowdown in housing could just as easily reverse previous consumption trends. A later National Bank of New Zealand Business Confidence report showed that investors grew slightly less pessimistic on the future of business trends, as the headline index eased to its best result in four months. Rising dairy prices and a falling exchange rate were largely responsible for the improvement, but the sentiment index nonetheless remains in strongly negative territory. Upcoming event risk will do little to clarify outlook for domestic expansion, with the sole release of ANZ Commodity Prices unlikely to force large moves in the Kiwi through short term trade.

The second-tier ANZ Commodity Price report is likely to show continued health in the prices received for domestic raw materials production, but currency markets are much more likely to trade off of general risk sentiment in the global economy. It remains relatively clear that speculators across the world remain unsettled following recent market turmoil, and it will be especially difficult for markets to stabilize given such adverse conditions. Indeed, expectations for overall volatility in currency markets remain at multi-year highs. Implied volatility on the New Zealand Dollar options contracts recently reached their highest levels on record. Though they have subsequently moderated, the key volatility measures remain near 2001 and 2004 highs. Given that the now-infamous global carry trade depends on relatively calm currency markets, it remains doubtful that the strategy may make a substantive rebound through short term trade. Such an outlook extends a bearish fundamental bias to the New Zealand dollar, which may continue to decline against major currency counterparts.

Boris Schlossberg is a Senior Currency Strategist at FXCM.