Strap on your seatbelts because it is going to be another active and busy week in the foreign exchange market. If you’ve watching the price action of currencies over the past week month or anytime since January, you may know that the U.S. dollar has been on a tear. Last week the greenback rose to fresh 4-year highs against the Japanese Yen, a new 1-month high against the euro and an 11th month high against the Australian dollar. On a trade-weighted basis as measured by the Dollar Index, the greenback reached a 3-year high. The sustainability of the dollar rally against all of the major currencies will hinge on what happens this week.
Don’t expect this week’s U.S. economic reports to be game changers for the U.S. dollar but what could affect how the dollar trades in a very big way is Fed Chairman Ben Bernanke’s testimony on the economic outlook on Wednesday. The relentless rally in the U.S. dollar indicates that investors are pricing in a major change in Fed policy. Bernanke’s comments pose a major threat to the dollar and could either support or end the dollar rally. A number of Fed Presidents (mostly non voting members of the FOMC) have called on the Fed to scale back the amount of assets purchases as quickly as June. This is not the same as “tightening” monetary policy but in the eyes of investors, it’s a step closer to that direction. If Bernanke drops even the smallest hint that they could vary bond buying – either by talking about it directly or sounding more optimistic about the outlook for the U.S. economy, the dollar could hit new highs. However if he spends more time talking about the constraints in the U.S. economy and the fiscal drag, the dollar fall quickly and aggressively as speculators cut their long dollar positions after realizing that mapping a QE exit doesn’t mean that the Fed is ready to head that way.
When we last heard from the U.S. central bank, they said they were prepared to increase or decrease the size of its monthly bond-buying program in response to changing economic conditions. Since then, we have seen record breaking moves in the stock market, a jump in consumer confidence and both improvement and deterioration in U.S. data. Job growth surprised to upside along with consumer spending but the recovery in manufacturing is losing momentum. As one of the more dovish members of the FOMC, we expect Bernanke to be very careful with his choice of words. After seeing how the markets have responded to the prospect of less QE, we don’t expect Bernanke to openly say that the economy has improved enough to warrant changes in monetary policy. Managing an exit won’t be easy and if anything, he will suggest that even if the Fed were to decrease asset purchases, they could increase them again if the economy weakens. In other words, while we don’t expect Bernanke to kill the dollar’s rally intentionally, his caution could lead to profit taking.
The FOMC minutes also poses more downside than upside risk for the greenback because the meeting took place before the latest non-farm payrolls report. The number the Fed most likely had on hand was 88k. If you recall, payrolls for March were revised up from 88K to 138K and then increased to 165K in April but we did not learn this information until 2 days after the FOMC announcement. Therefore the tone at the last meeting could more cautious with the doves screaming a little louder, which would not be good for the U.S. dollar.
There’s a number of Eurozone, U.K. and Australian event risks this week as well that could play a role in how the EUR/USD, AUD/USD and GBP/USD trades but we’ll spend more time on those as the week progresses. In the meantime, the primary threat to the dollar this week will be Bernanke’s testimony before the Joint Economic Committee and the FOMC minutes.
If Bernanke continues to sound cautious like some other FOMC voters who spoke last week, profit taking could drive the dollar lower making 1.28 in EUR/USD short term support and 103 in USD/JPY a near term top. But if we are completely wrong and Bernanke is on board with the idea of reducing asset purchases, expect USD/JPY to hit 104.50 and possibly even 105 and the EUR/USD to drop to 1.2700.
In the long run, we still expect more gains in the greenback relative to other currencies but we acknowledge that Bernanke poses a realistic threat to the rally this week.