Will Bernanke or Sequester Kill Dollar Rally?

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Daily FX Market Roundup 02-22-13

Will Bernanke or Sequester Kill the Dollar Rally?
EUR: Italian Election Scenarios
JPY: BoJ Governor Nomination Next Week
GBP: Rebounds on Lack of Data
CAD: Hit by Sharp Decline in Retail Sales
AUD: Supported by Steven’s Optimism
NZD: Oil Up, Gold Steady

Will Bernanke or Sequester Kill the Dollar Rally?

Thanks to the FOMC minutes and weaker economic data abroad, the U.S. dollar enjoyed a nice rally against most of the major currencies this week. The mere possibility that the U.S. central bank could start to taper off its monthly asset purchase program as quickly as next month sent investors rushing to adjust their positions. The unevenness of U.S. data makes it hard to believe that the economy is strong enough to withstand less stimulus but Fed President and FOMC voter Dudley made it clear that small adjustments could be made to ease the pain of stimulus withdrawal. The question is now where Bernanke, our mild mannered inflation dove stands. The head of the U.S. central bank will be delivering his semi-annual testimony on the economy to Congress next week. It is always an interesting session to watch particularly since there is a colorful question and answer session. If he agrees that changes to the monthly asset purchase could be made, the dollar could extend its gains quickly. However if he vigorously defends the central bank’s ultra easy monetary policy and downplays the need to slow or stop their asset purchases, it could kill the dollar’s rally.

Meanwhile there is another game of chicken being played in the U.S. government this week. A package of mandated spending cuts worth $85 billion known as the sequester are expected to kick in on March 1st. If Republicans and Democrats want to avoid these budget cuts, they need to come to a compromise and so far, there is little sign that they are willing to do so. Based on the rise in U.S. stocks today, equity traders aren’t worried perhaps because we’ve been down this road before with the debt ceiling and survived. Also, the numbers aren’t enormous – only $50B worth of cuts are expected this year, or the equivalent of 0.5% of GDP. While any type of budget cut will be painful for the U.S. economy and erode U.S. growth, Congress will most likely agree on a last minute deal. They could also make changes or cancel the cuts once they start to see the impact on the economy. Psychologically however, allowing the sequester to happen would still be negative for the dollar in the near term but over the long term, the impact should be nominal.

As for economic data, we only expect tier 2 economic reports next week. This includes house prices, consumer confidence, new home sales, durable goods, revisions to GDP, personal income, personal spending and the ISM manufacturing reports. All of these numbers will take a back seat to Bernanke’s testimony.

EUR: Italian Election Scenarios

The euro ended the week near its lows and whether it recovers or extends its losses from here will hinge on the outcome of this weekend’s Italian elections. Italian politics are a complete mess and with only two more days to go before the polls open, the lack of a clear frontrunner is extremely disconcerting. Bersani’s center-left party is still leading in the polls but by a small a margin. A clear majority win by the center-left party would be the best-case scenario and the most positive for the euro. A Berlusconi win on the other hand would be the worst-case scenario and could send Italian stocks and the euro sharply lower. Italy’s vote for Prime Minister will reflect the country’s vote for austerity. A Bersani win will be interpreted positively for Italian fiscal finances whereas a Berlusconi win will mean a return to the dangerous free spending days of a man nicknamed “Il Cavaliere” for his lavish lifestyle. Most likely if Bersani wins he would need to form a coalition with Mario Monti’s new centrists. The outcome of the Italian elections will drive euro flows at the beginning of the week but traders will quickly shift back to economic fundamentals on Wednesday / Thursday when we have Eurozone confidence, German unemployment and retail sales numbers. This morning’s better than expected German IFO report lent support to the euro but the nagging disconnect between the relatively upbeat sentiment readings and the dour economic data continues to hamper the currency. Meanwhile, the euro fell after the European Commission slashed its 2013 Eurozone GDP forecast to -0.3% from +0.1% but what really made the euro drop to session lows was news that LTRO II repayments fell short of expectations. Banks are set to repay only EUR 61.1B next week versus a forecast of EUR100 billion and the miss in LTRO repayment suggests that banks have less excess liquidity or free capital.

JPY: BoJ Governor Nomination Next Week

For the past 3 weeks, USD/JPY has consolidated, waiting for its next catalyst and that catalyst is expected to come next week with Prime Minister Abe’s Bank of Japan Governor nomination. The 3 main candidates are Iwata, Kuroda and Muto. The nomination of BoJ governor is expected to have a short term impact on the Yen with Iwata being the most bearish for USD/JPY and Muto being the most bullish, Kuroda is somewhere in the middle with a slightly negative bias. However the real reaction in USD/JPY will come when the candidate takes to the podium and starts talking about his commitment in monetary policy. At the end of the day however believe that regardless of which man Abe chooses, the new head of Bank of Japan will come out quickly and reaffirm his plans to follow through with reaching the government’s 2% inflation forecast which will require an aggressive amount of easing and drive the Yen lower once again. Based on the latest trade numbers, Japan’s economy needs a lot more help. Prime Minister Abe returns from his visit to the states on Monday and will most likely make his announcement at the front of the week.

GBP: Rebounds on Lack of Data

With no U.K. economic data on the calendar, the British pound stabilized against the U.S. dollar and rebounded against the euro. While we believe there are plenty of reasons why sterling will continue to fall, next week is a quiet one for U.K. data and that could drive a corrective recovery in the GBP/USD. However we look at this as an opportunity to sell the GBP at a higher level. Despite concerns about inflation, the dovish Bank of England minutes makes it clear that their primary focus is on growth and not inflation. In fact, in their Quarterly Inflation Report, the BoE even said they would look beyond this high period of inflation and the reason is because the lack of growth constrains producers from raising prices. The European Union also believes that growth in the U.K. economy will be modest this year. While the Commission left its projection for 2013 GDP growth unchanged at 0.9%, they cut their forecast for 2014 growth slightly to 1.9% from 2.0%. When Mark Carney takes over as the head of the Bank of England in July, he could take a more activist approach to monetary policy. That may be a few months from now but expectations for a more dovish monetary stance could keep the GBP under pressure.

CAD: Hit by Sharp Decline in Retail Sales

The Canadian dollar fell to a 7 month low against the greenback on the heels of disappointing economic data. The only economic report released from North American today was from Canada and unfortunately the deterioration compounded the losses in the Canadian dollar. Retail sales fell 2.1%, the most in more than 2.5 years. While part of the decline was caused by lower auto sales, purchases of furniture, electronic goods, and spending at department stores also plunged in the month of December. In fact holiday shopping last year in Canada was so weak that retail sales fell 2 out of the last 3 months of the year and this means that spending will contribute negatively to Q4 GDP. Combined with the meager 0.1% growth in consumer prices and we can understand why the Bank of Canada decided to tone down its level of hawkishness at their last meeting. USD/CAD has been on tear this month, rising from a low of 0.9933 to a high of 1.0232 today. Today’s move took the currency pair right to its 200-week SMA but if USD/CAD manages to break new highs, the next level of resistance isn’t until 1.04. The Australian and New Zealand dollars on the other hand performed extremely well after RBA Governor Glenn Stevens sounded surprisingly upbeat during his semi-annual testimony on the economy. He did not talk about the need for a rate cut at all and in fact said “there is a good deal of interest rate stimulus in the pipeline. At its meeting earlier this month the board judged that it was sensible to allow it time to do its work.” Investors had expected the RBA to cut interest rates by another 25bp at their March meeting but after Steven’s comments, these expectations have been pared significantly.

Kathy Lien
Managing Director

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