Behind the Recovery in EUR/USD

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Daily FX Market Roundup / Asia Preview 06-19-12

Behind the Recovery in EUR/USD
USD: Selling Dollars Ahead of FOMC
GBP: Inflation is Important to the Bank of England
AUD: RBA Minutes Reduce Odds of More Easing
CAD: Rise in Wholesale Sales Point to Stronger Spending
NZD: Current Account Deficit Expected to Narrow
JPY: Little Consistency in Price Action

Behind the Recovery in EUR/USD

While the foreign exchange market has turned its focus to the FOMC announcement on Wednesday, which we covered in detail in our FOMC Preview, the Federal Reserve’s decision and the actions of other central banks still hinge on what is happening in Europe. For this reason, it is important to understand what fueled the recovery in the EUR/USD and other major currencies. Although part of the recovery in risk can be attributed to expectations for dovish comments from the Federal Reserve tomorrow, investors also hope that European leaders are getting closer to forming a fiscal and banking union. The final G20 statement hasn’t been released but according to details shared by Canadian Prime Minister Harper, European governments are committed to doing all that they can to defend the euro. Hopefully this will include steps to strengthen the region’s firewall and a broader financial union that includes deposit guarantees that are tied to the region and not individual nations. According to EU President Van Rompuy, an economic union should be formed by the end of the year with major proposal and steps taking shape at this month’s EU Summit. How impressed the market will be will depend on the level of detail that Europe provides.

In the meantime, it is important for traders to continue to keep an eye on Spanish bond yields because it will determine the level of risk appetite in the market. Thanks to a T-bill sale that was slightly above target, Spanish ten year yields are back below 7%, helping to stem the losses in the euro. Economic data continues to deteriorate with the German ZEW survey falling the most since 1998. Consumer confidence has been hit hard by the sovereign debt crisis and the banking troubles in Spain. The index fell from 44.1 to 33.2 in what is clearly a reflection of panic amongst investors. Despite the latest recovery in the EUR/USD, we suspect that confidence remains extraordinarily weak. German producer prices are scheduled for release tomorrow and the data will most likely show inflationary pressures easing in the month of May. Inflation expectations are well contained which means the European Central Bank has plenty of room to ease.

USD: Selling Dollars Ahead of FOMC

Investors sold dollars ahead of the FOMC announcement in anticipation of cautionary and dovish comments from the Federal Reserve. This sentiment is a bit surprising considering that less than 2 weeks ago, Fed Chairman Ben Bernanke downplayed the weakness of the U.S. labor market and reset the market’s expectations for more stimulus in the process. Investors are clearly skeptical about Bernanke’s nonchalant attitude on non-farm payrolls and believe that even if there is no QE3 tomorrow, the Fed will reassure the market that monetary policy remains extremely accommodative and they are ready to do more if necessary. The dollar will weaken if Bernanke admits that QE3 is still a possibility, but if he spends more time talking about the distortion that the warm weather had on U.S. data, the dollar should rise. We do not expect Wednesday’s FOMC announcement to be one of those gaming changing monetary policy events but with Bernanke holding a press conference and the Fed releasing their revised economic projections, it could still be a volatile trading day. The actual decision about monetary policy should be an easy one – extend Operation Twist and nothing else. If the anti-austerity party won the Greek elections causing a sell-off in financial markets around the world, the FOMC decision would be a tougher call. The rest is more complicated as the high level of unemployment could alter the central bank’s projections. Bernanke’s comments will also be important and hopefully this time around he has learned to clarify instead of confuse traders because in this past, his views have conflicted from the Fed projections.

Here’s the schedule for tomorrow:

12:30pm ET / 16:30GMT – FOMC Rate Decision
2:00pm ET / 18:00 GMT – Fed Releases Projections for Economy and Fed Funds Rate
2:15pm ET / 18:15 GMT – Bernanke Holds Press Conference

Eight weeks have passed since the last monetary policy meeting in April and here’s a look at how the U.S. economy has changed. While some parts of the housing market have shown signs of life, there has been broad based deterioration in the rest of the economy. The sluggish pace of job growth and sharp decline in equities made consumers more nervous and less willing to spend. The stronger dollar and lower commodity prices also eased inflationary conditions, giving the Federal Reserve further room to ease. The only question is will they.

GBP: Looking for Dovish BoE Minutes

Despite a surprise decline in consumer prices that raises the chance of stimulus from the Bank of England, the British pound traded higher against the U.S. dollar. Optimism about more support for the Eurozone helped sterling traders shrug off the news but at the end of the day, it is important to remember that the decline in inflation raises the chance of more QE from the BoE. We know that the monetary policy committee is worried about the outlook for the U.K. economy and is already leaning towards additional asset purchases. Tomorrow we will learn exactly how many members voted in favor of QE earlier this month. Coming on the heels of a round of weak data, there’s a good chance that Posen and Miles won’t be the only two MPC members calling for more stimulus. If 3 policymakers or greater voted to ease, the GBP/USD will weaken. If 2 members voted but the minutes reveal an inkling to do more, the GBP/USD could still suffer but if only 1 member voted to increase asset purchases, the British pound will rally. This scenario is unlikely given recent comments from Posen. Furthermore the lowest inflation reading since December 2009 provides the central bank with a plenty of cover to ease again. Aside from the BoE minutes, employment numbers are also scheduled for release. Jobless claims are expected to decline for the third consecutive month.

AUD: RBA Minutes Reduce Odds of More Easing

The Australian, Canadian and New Zealand dollars traded higher against the greenback thanks to the improvement in risk appetite. According to the minutes from the most recent Reserve Bank of Australia monetary policy meeting, the most recent rate cut by the RBA was “finely balanced.” The release of the RBA minutes revealed a discussion of how the worsening of global prospects was stalling the growth in the domestic economy. It became clear that cutting the cash rate was a solution to counter the increasing uncertainty of the euro crisis and softening of the global economy. Interest rates were cut by 25 basis point to 3.5%. It seems that lowering rates was more to combat global than domestic factors. The minutes suggest that the RBA will not be as generous about cutting interest rates moving forward. At one point, the market had priced in 100bp of easing by the central bank before the end of the year. Now, further rate cuts will depend largely on developments in Europe. Leading indicators are scheduled for release this evening along with dwelling starts. No economic data was released from New Zealand overnight but the country’s current account figures are due this evening. In Canada, wholesale sales jumped 1.5 percent, which is indicative of a recovery in spending. This report tends to have a good correlation with the nation’s official retail sales report.

JPY: Little Consistency in Price Action

The Japanese yen weakened against all major currencies with the exception of the US dollar. Asian stocks dropped on BoJ Governor Shirakawa’s message to lawmakers that the euro crisis will be Japan’s greatest risk and concern. Leading indicators were revised higher in April but risk appetite dictated the price of the EUR/USD. Tonight at 19:50 ET / 23:50 GMT the BoJ will publish the minutes to their meeting on May 22-23 and Japan will release its data for Merchandise Trade Balance Total. Tomorrow at 0:30 ET / 4:30 GMT the data for All Industry Activity Index will be released. The data for foreign ownership in Japanese stocks and bonds and Japan’s ownership on foreign stocks and bonds will be released at 19:50 ET / 23:50 GMT. Foreign ownership of Japanese bonds was at a record high in 2011 while Japan households’ holdings fell the lowest since 2005 indicating Japan’s dependency on foreigner to finance their public debt. It will be interesting to see what the numbers in June look like.

Kathy Lien
Managing Director

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