Yellen Testifies Tuesday – Buy or Sell the Dollar?

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Daily FX Market Roundup 07.14.14

Yellen Testifies Tuesday – Buy or Sell the Dollar?

GBP: Next 24 Hours is Key

EUR: Draghi Says QE Falls into ECB Mandate

AUD: What to Expect from the RBA Minutes

NZD: Service Sector Activity Accelerates

USD/CAD Retreats after Strong Gains on Friday

JPY: No Action Expected from BoJ

Yellen Testifies Tuesday – Buy or Sell the Dollar?

Lets start by establishing the facts. Here’s what we know going into Yellen’s speech:

1. U.S. Economy is improving but at a painstakingly slow pace (labor up, activity down)

2. Inflation is bottoming

3. Quantitative Easing will end in October

4. Yields are extremely low with the market underpricing 2015 tightening vs. Fed’s forecasts

5. Fed doesn’t expect to raise interest rates until mid 2015.

What does this mean?

1. Fed tightening is still a year away

2. We are looking at another 8 to 12 months of ZIRP

3. Yellen will look to distinguish the difference between tapering and tightening

4. ***Don’t Expect any New Signals on Monetary Policy from the Fed until September = Positive Carry

Janet Yellen’s semi-annual testimony on Capitol Hill tomorrow is the most highly anticipated event risk this week. In the most ideal scenario traders are hoping for 2 outcomes – an increase in volatility that widens ranges for currencies and clarification on when the central bank will raise interest rates. Unfortunately sharing this information won’t create the best outcome for the Fed. While policymakers around the world are worried that low volatility is creating complacency in the financial markets, they do not want monetary policy signals to cause unneeded volatility, especially at critical points in their recovery. Even though yields moved higher ahead of Yellen’s testimony, in all likelihood, her comments will fail to satisfy dollar bulls and the market in general. In other words, we see more downside than upside opportunity for the dollar tomorrow but the smarter move may be to wait for Yellen to speak before taking action because only a surprise will provide us with a tradable move in currencies. Traders should look to buy dollars if Yellen acknowledges the recent improvements in the economy and says that rates could rise early next year. However if she goes out of her way to distinguish the difference between the end of tapering and the beginning of tightening and refuses to specify when rates will rise, the dollar should decline which could provide an opportunity to sell the greenback but the opportunity is less attractive since we believe the downside in the dollar is limited. JPMorgan published an interesting study over the weekend that found that since 2009, volatility in Treasuries increased in the week prior to the semi-annual testimony and compressed on the day of, which is an argument in favor of a benign reaction to the testimony. U.S. retail sales and corporate earnings are also scheduled for release tomorrow and we wouldn’t be surprised if they end up having a bigger impact on the dollar. Instead the best trade is to be long carry going into and on the back of Yellen’s testimony.

GBP: Next 24 Hours is Key

For the British pound, the next 24 hours is extremely important. Not only is the consumer price report scheduled for release but the Bank of England’s Carney, Kohn, Taylor and Bailey will be testifying to the Treasury Committee on the June Financial Stability Report. If you recall investors were unimpressed by the central bank’s announcements in June and they will now be looking for hints of more action from the central bank. Recent U.K. data has been disappointing but overall the economy is doing well and the housing market remains strong, keeping pressure on policymakers to take additional action. However housing is the only part of the economy experiencing inflation. Consumer prices are expected to remain muted after the decline in shop prices last month and until there are signs of significant wage growth, the Bank of England won’t be in a rush to raise rates. We will get a better look at wage pressure later this week. GBP/USD dropped to a fresh month to date low this morning ahead of the testimony and CPI report. If inflationary pressures pick up and policymakers suggest that rates could rise this year, GBP/USD could head back to its 5 year high but if inflation slows and the BoE downplays the need for tightening, 1.7000 will be the target for the currency.

EUR: Draghi Says QE Falls into ECB Mandate

Dovish comments from ECB President Draghi and a decline in Eurozone industrial production did not stop the euro from trading slightly higher against the U.S. dollar today. In his testimony before the European Parliament, Mario Draghi said domestic demand has been the main source of growth and he expects demand to continue to support the recovery. However with unemployment still high and capacity underutilized, he believes that the risks are to the downside. Inflation is expected to remain low for the coming months and as a result, the central bank is intensifying preparations for an Asset Backed Securities purchase program. Unlike members of the EU who raised concerns about the ECB’s mandate, the central bank President believes that Quantitative Easing “falls squarely” within their mandate. With these comments, Mario Draghi is making it clear that the ECB remains dovish and “ready to take additional action if necessary” but based on the price action of EUR/USD, investors are rightfully skeptical of the central bank’s conviction. We continue to believe that the ECB won’t increase stimulus in the next 2 months.

AUD: What to Expect from the RBA Minutes

The Australian dollar had a quiet start to a busy week but volatility should pick up starting with the release of the minutes from the last Reserve Bank of Australia monetary policy meeting. Over the weekend, RBA Governor Glenn Stevens attempted to talk down the currency but the market paid very little attention to the jawboning. He said the AUD’s value is too high and warned that investors are underestimating the possibility of a decline. Without a clear threat to intervene, criticism can only bring AUD down so far whereas dovish minutes could ease upside pressure on the currency. At the last meeting, the Reserve Bank of Australia left monetary policy unchanged and contrary to everyone’s belief at the time, the statement did not reiterate the dovishness seen in last month’s RBA minutes. The central bank stuck to script and even sounded a bit upbeat on the outlook for China. However we’ve seen this happen before, where the currency sells off when the minutes contain a more cautious tone than the statement. Going into the July meeting, the market anticipated concerns about mining investment, commodity prices, the strong currency and fiscal tightening. While none of this appeared in the statement it could surface in the minutes especially after the country’s trade deficit ballooned to it largest level ever in 18 months. Meanwhile the New Zealand dollar failed to receive much support from stronger service sector activity. For NZD/USD, 0.8842 is significant resistance and a very firm report will be needed to drive the currency pair above this level. No economic data was released from Canada but after Friday’s sharp rise, USD/CAD retreated slightly in quiet trade.

JPY: No Action Expected from BoJ

The Bank of Japan is widely expected to leave monetary policy unchanged this evening. The recovery in U.S. yields today helped to stem the slide in USD/JPY. How the currency pair and the yen crosses trade from here will be determined by the monetary policies of the Fed and not the Bank of Japan. In the coming week, there are no shortages of event risks that will affect USD/JPY but at the end of the day, we continue to believe the 100.75 to 103 range for the currency pair will remain intact. Given recent data improvements, the only possible surprise from Yellen would be in the form of a clear signal of when rates will rise, a development that would be positive for USD/JPY. On the downside, the main risk is a deep sell-off in equities that is driven by major disappointments in earnings and/or another unexpected shock like Portugal’s banking troubles. The lowest level that 10-year yields dropped to this year was 2.44% on May 28th and even if Yellen fails to satisfy the market, we do not expect this level to be tested. Given the correlation between USD/JPY and Treasury yields, this should translate into only limited weakness for USD/JPY.

Kathy Lien
Managing Director

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