US Dollar: Make or Break Week as the Fed Decides the Taper

US Dollar: Make or Break Week as the Fed Decides the Taper

Fundamental Forecast for US Dollar: Bullish

• Dollar suffers significant bearish break on biggest S&P 500 rally this year
• Fed mouthpiece Hilsenrath sets tone for critical June policy decision
• US Dollar looks to set up strong trading opportunities for mid-week

The Dow Jones FXCM Dollar (ticker = USDollar) endured a critical tumble this past week – a move that threatens to seismically alter a nine-month bull trend for the currency. Yet, both technical break and trend ambitions can be immediately reversed by one critical piece of event risk: the Federal Reserve’s June rate decision. Already an important event for gauging the level of external support for investor sentiment and US rates, the market-moving potential surrounding this affair has been amplified by heavy speculation, a poor reaction from Japanese markets to BoJ QE and the slow realization of excessive leverage in the market.

Monetary policy – particularly that of the Federal Open Market Committee (FOMC) – is a critical part of the market infrastructure at this point. Back in the rout of 2008, the first moves were made by the Fed and Treasury to prevent a collapse in the financial system – a noble cause. After the first quarter of 2009, though, the central bank moved back to its primary mandate of promoting steady inflation and full employment. The first quantitative easing (QE) programs were aimed at reducing market rates further than the cuts to the Fed Funds rates could achieve. In the more recent phase of the recovery, the objectives of policy have blurred. While the mandates remain, an obvious and dangerous side effect has resulted from the support: the capital market’s dependency on stimulus to charge record highs. We almost certainly wouldn’t have seen a record S&P 500 so soon if it weren’t for QE2 and QE3, so what happens when the programs end? Will innate growth and investment simply supplant the moral hazard and keep us at record highs? Unlikely.

The June 19th policy decision is not our run-of-the-mill Fed event for a number of reasons. First and foremost, this is one of the group’s quarterly events in which they deliberate policy, update forecasts (growth, inflation and interest rates) and offer up Chairman Bernanke for a press conference. As a monetary policy authority, this is an ideal opportunity to explain a difficult decision to a market that is almost certainly prone to ‘over-reacting’ (a term that central bankers and economists would use, but traders should recognize is inappropriate). A difficult period does lie ahead for the Fed: the ‘Taper’. This term refers point at which the $85 billion-per-month purchases of Treasuries and Mortgage-Backed Securities (MBS) under the QE3 program are finally reduced. This would not represent a tightening in policy, rather it is a reduction in the pace of expansion.

The difference between the Taper and an actual unwinding in stimulus or rate hike is severe. Yet, that won’t matter to the market. Speculators are forward looking. They front-run what is likely to happen in the foreseeable future. Just as industrious traders have moved in ahead of the Fed by buying Treasuries or applying leverage to markets like stocks, they will also look to pull back before the central bank does. That means that an announcement that the monthly stimulus clip will be reduced can very likely send the market in a scramble of risk aversion – a move that could cave over-extended capital benchmarks (S&P 500) and rally safe havens (like the dollar).

What is the chance that the Fed announces a tapering at this June meeting? It is less than 50-50. While we have seen an improvement in data since the last policy decision and tempering of the equities markets has been steady, there is benefit in spending more time acclimatizing the market to the reality that the support will eventually be reined in. Looking at the balance of biases amongst the FOMC voters, there are few calling for an immediate pullback. Key members that fall into the ‘neutral’ category have suggested they would prefer 2-3 more months of data. That would work with Bernanke’s Congressional testimony that a taper could occur within the same time frame.

For trading scenarios, an actual move to reduce QE purchases would be seen as a surprise to the bulk of the market; and the risk aversion impact would be severe. A smaller reduction (such as a modest $5 billion slowing) would generate less short-term volatility, but it would set off a wave of deleveraging through the medium-term regardless. A larger cutback ($10-25 billion) would combine both serious volatility and trend. That said, the more likely outcome is to keep the program as is for this month.

Should we come through the program with no change to the stimulus programs, we could still end up with a serious trend development via guidance. If Bernanke uses his press conference or statement to warn the market that the next regular or September meeting will introduce the inevitable shift, the front-runners will take it as a sign. There is little chance of an outcome that provides anything longer than a short-term bullish reaction for risky assets (bearish for the safe haven dollar). – JK

--- Written by: John Kicklighter, Chief Strategist for DailyFX.com

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Euro and US Dollar Traders on Edge Ahead of Critical FOMC Decision

Euro and US Dollar Traders on Edge Ahead of Critical FOMC Decision

Fundamental Forecast for Euro: Bullish

• Euro poised to test fresh highs as sentiment still one-sided
• US Dollar suffers major break against the Euro – is it fatal?
• Euro traders eye potentially significant OMT decision as key risk

The Euro finished higher against the US Dollar for the fourth-consecutive trading week, good for its largest win streak since September and leaving it poised to test fresh peaks. A critical US Federal Open Market Committee rate decision in the week ahead looms large for all US Dollar pairs, but it might take a big surprise to allow the Dow Jones FXCM Dollar Index (ticker: USDOLLAR) to recover from its recent sell-off.

Traders headed into last week still net-short the Euro versus the US Dollar, and broader market sentiment suggests that the Euro may continue higher as traders unwind USD-long positions. But further Greenback losses and Euro gains aren’t foregone conclusions—particularly as the US Fed is set to deliver a potentially pivotal interest rate decision on Wednesday afternoon.

Event risk for the Euro Zone is comparatively limited, but it will be important to watch for surprises from the German Constitutional Court ruling on the legality of the European bailout plan. German ZEW investor sentiment data and PMI figures could likewise spark short-term moves, but it might take some especially-large surprises to distract traders from much-larger market themes.

The key theme/phrase in markets through recent price action has undeniably been “taper”. In short: when will the Federal Reserve begin to “taper” its aggressive Quantitative Easing policies and bond purchases? (What is the taper and why does it matter?)

Though it seems exceedingly unlikely that Chairman Ben Bernanke will announce a cut in QE on Wednesday, traders will watch for every clue on when the Fed might cut back on asset purchases. Why?

The US Federal Reserve has led global central banks in unconventional monetary policy easing on an unprecedented scale, and financial markets have seen similarly historic improvements on said policies. Even the thought that the Fed could soon slow its purchases has sent a chill down investors’ spines. No one wants to be the last one out of the “QE trade”, and we’ve seen some panic-driven sell-offs in the S&P 500 and even US Treasury markets as speculators charge for the exits.

Bernanke knows all of this of course, and it seems unlikely that the FOMC statement shows an especially hawkish shift in rhetoric. But recent market reactions to relatively insignificant data prints suggest the Fed doesn’t have to show a big shift. Markets are on edge, and the FOMC statement could be a game-changer.

How all of this plays out will likely determine Dollar direction versus the Euro and other pairs through the foreseeable future. Though it seems counterintuitive at first glance, we believe that the USD might actually decline if we see big sell-offs in the S&P 500 and Treasuries. Why? That’s exactly what’s happened in the past three weeks, and that’s because speculators remain heavily long the US Dollar.

Indiscriminate market deleveraging would likely force traders out of USD-long positions and might actually benefit the EURUSD. That isn’t our base case projection, but it’s certainly possible and traders should be aware of said risk.

Watch for surprises out of the Fed and lower-tier event risk from the Euro Zone. Forex volatility prices are at their highest levels on the year, but the past several years show us that markets could become much more volatile. - DR

Yen’s Gains to Extend as BoJ Stands Pat, Fed Tapers Less than Expected

Fundamental Forecast for Japanese Yen: Bullish

- The BoJ is Fighting an Over-Extended USD/JPY and Other Yen Crosses

- USD Losses Limited Ahead of FOMC, BoJ Pause to Support JPY

- Yen’s Outperformance Continues; Euro Slips Despite Stronger Peripheral Debt

The Japanese Yen was the top performing currency this past week, gaining +3.45% against the US Dollar, with the USDJPY closing at ¥94.10, the lowest level since April 4, the day the Bank of Japan announced its sweeping QE measures that ultimately propelled the pair through 100.00 within four weeks. Although the Yen weakened through Monday following the May US labor market report beat on June 7, the BoJ’s policy meeting on Tuesday failed to produce the necessary result to put the Yen back on the schneid: measures to address recent JGB volatility.

The BoJ’s May meeting Minutes released on Thursday, although containing stale information from the pre-Nikkei rout period (which began on May 23), showed that the central bank wasn’t concerned at all with pending volatility in Japanese financial instruments. However, in what was prescient commentary, at least one member said that recent policies risked provoking volatility in bond markets due to unrealistic expectations. This view was met with opposition that the BoJ’s large scale asset purchases would keep downward pressure on yields. At this point, we know now that this single member was correct; but the collective opinion reigns, meaning that no new measures should be expected - and that any short-term liquidity measures would more-or-less amount to a Japanese-styled LTRO (of the ECB in December 2011 and February 2012), which may not be enough to end recent anxiety.

Truly, at this point in time more than ever, the BoJ is one of two domestic fundamental factors that are influencing the Yen, the other being ‘Abenomics.’ In its current iteration, ‘Abenomics’ is on hold, in so far as recent 1Q’13 GDP figures were revised higher, and Japanese diet elections in mid-July, given the controversy around 'Abenomics,' he's unlikely to push new measures before then. At this point in time, it makes little sense that Japanese Prime Minister Shinzo Abe would spend the political capital when he can wait a few more weeks after his party wins the diet elections.

With respect to the USDJPY specifically, the Federal Reserve’s June 19 meeting will undoubtedly produce excess volatility in the pair, given the speculation surrounding the state of QE3. Ahead of the Wednesday meeting, it’s evident that the market is pricing in a fairly sharp slowdown in QE3 - perhaps seeing the program wound down by $25B to $35B. This expectation appears excessive given subdued core inflation pressures and labor market growth at only a modest pace. (The 3-month, 6-month, and 12-month averages all dropped as a result of the May NFPs print.) If there's a reduction in QE3, it will be much smaller than market anticipants are pricing in; anything less than $15B could lead to a rally in US Treasuries in the short-term, putting further pressure on the USDJPY.

Elsewhere, the commodity currencies – the Australian, Canadian, and New Zealand Dollars – remain under fire due to the increasingly negative outlook on Chinese growth, which sees no signs of abating in the near-term. But for market positioning for the commodity bloc – market participants are extremely short – a greater pullback in the AUDJPY, CADJPY, and NZDJPY is a reasonable expectation at this juncture, although range trade conditions could be present this week as commodity bloc positioning moderates and the Yen rallies following the Fed’s rate decision on Wednesday.

In terms of the European currencies versus the Yen, the EURJPY looks the weakest amid widening periperhal-to-core bond yield spreads, notably the widening of Italian-German and Spanish-German differentials since the European Central Bank’s Rate Decision on June 6. European equities closed down for the fourth consecutive week, calling for a greater correction in the Euro. Overall, the tone here is clear: the ‘risk off’ nature of the market is spreading quickly, and the conditions have aligned for further Yen strength going forward.

--- Written by Christopher Vecchio, Currency Analyst

To contact Christopher Vecchio, e-mail cvecchio@dailyfx.com

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British Pound Eyes Fresh Highs on Faster Inflation, BoE Minutes

British Pound Eyes Fresh Highs on Faster Inflation, BoE Minutes

Fundamental Forecast for British Pound: Bullish

• GBP/USD Pressing Channel; 1.5783 Measured Level is of Interest
• Price & Time: Pound Nearing Critical Levels
• GBP Rebound Limited by 1.5780 Threshold- Short Scalps on Tap

The British Pound extended the rebound carried over from the previous month, with the GBPUSD climbing to a fresh monthly high of 1.5736, and the sterling may continue to appreciate next week should the fundamental developments coming out of the U.K. further dampen speculation for additional monetary support. Although the Bank of England (BoE) Minutes highlights the biggest event risk for the following week, we’re expecting to see the headline reading for U.K. inflation increase at a faster pace in May, and the stickiness in price growth may prompt the central bank to switch gears later this year in an effort to safeguard its credibility.

Indeed, the BoE Minutes should reveal another 6-3 split within the Monetary Policy Committee after the central bank refrained from releasing a policy statement at the June 6 meeting, and the fresh batch of central bank rhetoric may increase the appeal of the sterling should the board show a greater willingness to conclude its easing cycle in 2013. Beyond the vote count, we’re also very interested to see the updated assessment, and we may see a greater argument to keep the Asset Purchase Facility capped at GBP 375B as the region skirts a triple-dip recession. As Governor Mervyn King sees a sustainable recovery in the U.K., the MPC may adopt a more hawkish tone for monetary policy in the second-half of the year, and the committee remains poised to operate under its inflation-targeting framework as the region is expected to face above-target price growth over the policy horizon. Although there are bets that the next central bank governor, Mark Carney, will implement a growth target for monetary policy, the majority may downplay the benefits of adopting such a policy as they struggle to bring down inflation back towards the 2% target.

As the GBPUSD clears the 38.2% Fibonacci retracement from the 2009 low to high around 1.5680-90, we may see a move towards the 100% Fib extension from the March low (1.4830), but we will need to keep a close eye on the relative strength index as it approaches overbought territory. In turn, we may see the GBPUSD mark a fresh high before we get a correction, and we will look for opportunities to buy dips in the pound-dollar as it preserves the upward trend from earlier this year. - DS

Gold Break Out Imminent on FOMC Rate Decision- $1355 Key Support

Gold Break Out Imminent on FOMC Rate Decision- $1355 Key Support

Fundamental Forecast for Gold: Neutral

• Gold is Too Quiet…Expect Something Soon
• Crude Oil, Gold Look to US Retail Sales Data for Fed Policy Clues
• Gold Low of Day Registered Just Below Key Level

Gold crept higher this week with the precious metal posting a modest advance of just 0.36% to trade at $1387 at the close of trade in New York on Friday. Bullion price action has remained rather subdued despite the wide spread volatility seen in FX and broader equity markets with prices continuing to hold steadily below the $1400-threshold. All eyes now turn to key event risk next week as prices continue to coil into a clearly defined range.

Looking ahead to next week investor focus remains fixated on the FOMC policy decision on Wednesday. This time around we get the updated quarterly projections from the committee on inflation, growth, and the interest rate. For weeks the markets have been roiled by the notion that the Fed may begin to taper its QE operations during the summer and market participants will be lending a keen ear to Bernanke’s subsequent press conference for further clarity on where the committee stands. Regardless, the event may be just the catalyst needed to get the gold trade back on track with a break of a multi-month consolidation pattern likely to offer further clarity on gold’s current positioning.

From a technical standpoint gold has continued to trade into the apex of a wedge formation dating back to the April lows with a break next week likely to offer further conviction on a near-term directional bias. A break below interim support at $1356 opens up targets at $1340, $1331 and $1307 while a breach above the monthly high at $1423 eyes a key resistance range between $1430- $1440. Only a break above this mark invalidates our broader directional bias with such a scenario eyeing subsequent targets at the 100% extension taken off the May lows at $1451 and t$1470. –MB

Canadian Dollar To Consolidate Ahead of GDP Report

Canadian Dollar To Consolidate Ahead of GDP Report

Fundamental Forecast for Canadian Dollar: Neutral

• USD/CAD Pullback May Yield Long Entry
• US New Home Sales Rose to 417K; USDCAD Mixed
• Canadian Dollar Gains after March CPI Slows down

The Canadian dollar strengthened this week against its U.S. counterpart on an improved economic outlook in the U.K. and U.S. Britain managed to avoid a triple-dip recession, recording a positive growth rate in the first quarter. Meanwhile, the U.S. jobless claims report came out better than expected as first-quarter GDP grew at a moderate rate, further helping to push the loonie higher. Also, Crude oil, Canada’s biggest export, rebounded, and hit its highest level in two weeks. Looking forward, we may see the Canadian dollar consolidate and build a short-term base before making another major move to the upside.

Canada’s February Gross Domestic Product highlights the biggest event risk for the week ahead. According to a Bloomberg News survey, economists have called for a consensus estimate of 0.2 percent growth in GDP, the same pace as in the previous month. In his last testimony before parliament, Bank of Canada Governor Mark Carney said that “Canada’s economy is strong but still faces risks.” Furthermore, signs of improvement in the domestic economy have materialized recently, with positive data in the manufacturing and sales sectors. At the same time, the latest unemployment rate report indicates that the recovery in the labor market remains slow. As a result, uncertainties in Canadian fundamentals could lead to a disappointing GDP report, potentially dragging down the loonie

Inflation within Canada has remained low in recent months, but is expected to gradually rise to the target level of 2 percent by mid-2015, when the economy is expected to return to full capacity. Although the Bank of Canada chose to hold its benchmark interest rate at 1.0 percent, the continual threat of record-rising household indebtedness could cause the central bank to hike interest rates in order to make borrowing more difficult and expensive. However, Governor Carney softened his tone on such a rate increase after growth unexpectedly stalled. The central bank cut its 2013 growth forecast to 1.5 percent from 2.0 percent. In addition, the IMF’s latest report suggested that Canada should refrain from tightening its monetary policy until its economy improves. In order to get a clue on the timing of interest rate move, investors will want to keep a close eye on three factors: economic growth, personal debt, and aspects of the housing market. With rates currently as low as they are, the Canadian dollar has less upward support.-RM

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Australian Dollar Still Vulnerable But Reversal Risk Mounting

Fundamental Forecast for Australian Dollar: Neutral

• Australian Dollar Yields Tepid Response to RBA Interest Rate Decision
• AUD/USD Technical Analysis: Selling Pressure May Be Losing Momentum

Capitalize on Shifts in Market Mood with the DailyFX Speculative Sentiment Index.

The Australian Dollar found itself under pressure once again last week as shifting monetary policy expectations continued to undermine demand for the high-yielder. The sharp swoon in the AUDUSD exchange rate since the beginning of May has been accompanied by a brisk narrowing of the yield spread between benchmark US and Australian 10-year bond yields. This implies an Aussie-negative realignment of investors’ perceptions of relative returns to be had from holding one currency over the other. That spread ended last week at 1.0892 percent, a hair above the record low at 1.0711 percent recorded in November 2008 at the height of the global financial crisis.

The week ahead brings another round of top-tier fundamental event risk to inform policy expectations.On the Australian side of the equation, the spotlight will be on the Employment report. Expectations suggest the economy lost a net 10,000 jobs in May while the unemployment rate reversed April’s improvement, returning to the 40-month high set in March at 5.6 percent. The outcome may reinforce bets on a July interest rate cut from the RBA, which traders now price in with a 55 percent probability according to data from Credit Suisse. This would encourage continued narrowing of the yield spread, weighing on the Aussie.

Meanwhile in the US, the central topic of conversation remains the likelihood and timing of a reduction in the Federal Reserve’s monthly asset purchases. The US Dollar rose on Friday after a slightly larger than forecast increase in nonfarm payrolls in May was countervailed by a downward revision to the April reading, yielding an outcome broadly in-line with expectations on net. Traders that feared an upside surprise might hasten the Fed’s hand cheered on the result, with a swell in risk appetite pulling Treasury yields higher and offering support to the greenback.

In the coming days, the May Retail Sales report and June’s preliminary University of Michigan Consumer Confidence figure take top billing. Results in line or worse than expected may further distance the threat of a reduction in Fed support in the mind of investors, boosting sentiment and sending US bond yields upward. That would help further shrink the spread between the relative return on US and Australian Dollars in favor of the greenback, lending a hand to AUD/USD sellers. Needless to say, stronger results promise the opposite results.

Perhaps most critically, the market has become intensely data-dependent, making for a volatile environment. Furthermore, while a swell in futures volumes suggest the recent selloff is underpinned by strong commitment, Australian Dollar net-short positioning is now at a record high. This warns makes for a market vulnerable to aggressive profit-taking if news-flow offers even a somewhat lackluster catalyst.

New Zealand Dollar to Hold Range Ahead of RBNZ

New Zealand Dollar to Hold Range Ahead of RBNZ

Fundamental Forecast for New Zealand Dollar: Neutral

• New Zealand Dollar Flat As Service Sector Remains Expansionary
• Kiwi Surges As N.Z First Quarter CPI Rises Less-Than-Expected
• Risk-On Sends Pound, Kiwi Higher on the Back of the Yen

The New Zealand Dollar ended the week nearly 2.0 percent lower, a dramatic turnaround from previous weeks. After disappointing Chinese data showed slower than expected growth in New Zealand’s biggest business partner, investors were forced to reconsider their positions in the kiwi. In addition, weak US data and a collapse in the prices of precious metals dragged down risk-linked currencies like the New Zealand Dollar. On the other hand, New Zealand’s first-quarter Consumer Price Index met economists’ forecasts and has grown at a steady pace. Looking forward, given this positive and negative momentum, we may see the kiwi rebound within range.

The main event risk for the New Zealand Dollar next week comes in the form of the central bank rate decision scheduled for Tuesday. Currently, the country’s overall inflation pressures remain subdued, growing at a pace below the Reserve Bank‘s bottom target range for the third consecutive quarter. Recently, the currency’s high exchange rate has placed downward pressure on the price of traded goods such as imported household items. According to the RBNZ there are some growing concerns over the “current escalation of house prices”, which continue to climb, particularly in the country’s two largest cities, Auckland and Christchurch. However, the increase in rents and construction costs are not as significant as expected and there is little sign of a spillover in rebuild-related inflation in other regions of New Zealand outside of Canterbury. Domestic inflation is expected to rise gradually with the economic recovery, but is likely to remain in the bottom half of the central bank's target zone throughout the rest of this year. Consequently, the RBNZ’s inflationary concerns are minimal and the RBNZ may hold interest rates at record lows in order to boost jobs and help exporters who are hampered by a strong kiwi.

On the Chinese data front, the April Manufacturing PMI and Business Sentiment Indicator reports will be the top drivers for the New Zealand Dollar. New Zealand’s small market size limits its global competitiveness and the nation’s economy has become closely correlated with that of China, similar in nature to the relationship between Canada and US. Despite China’s first-quarter GDP shortcomings, the nation’s recovery continues to be lead by improving domestic demand. As we discussed last week, signals continue to suggest that China is moving away from export-led growth to import-led growth. During this transition period, we may see some volatility and a subsequent economic slowdown in the short term. In the long term, however, China’s enormous population (1.3 billion) has the potential for significant consumption should individual savings be reduced from their current levels of 50% of income. This long term perspective adds positively to the outlook of New Zealand and its currency.

The pace of the kiwi's weekly decline slowed following a Bloomberg News report concerning a G-20 draft statement, which affirmed a commitment, among the 20 nations, to avoid purposely weakening their currencies in order to gain a trade advantage. Previous gains in the Kiwi were largely driven by the increasing demand among investors who were looking for positive returns outside of Japan. As a result, traders should focus on the G-20 meeting over the weekend, as markets will look for any comments about Japanese currency intervention.

-RM

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