Dollar Suffers Biggest Drop In 11 Months, Will RBA Curb Aussie's Rally?

The dollar dropped against all of its liquid counterparts to open this week and the Dow Jones FXCM Dollar Index (USDollar) suffered its sharpest single-day decline since June 29, 2012. While a late-day advance for US equities offered a pro-risk theme to shore up the fundamental reasoning for the benchmark currency’s slump – the move speaks to the market’s other major theme: speculation on stimulus and the ‘taper’. Through May, the dollar charged higher against the current of speculative appetite reflected in the standard-bearer S&P 500’s climb. The stock market’s source of strength has been the latent momentum behind the stimulus build up by the Fed over the past few years – which is running more and more on familiarity rather than fresh help. From the currency, the early speculation that the open-ended stimulus regime would take its first step back from constant escalation in the coming months or weeks drew the skeptics fearing the moderation of stimulus and its risk impact.

Between the positive performance for the S&P 500 and the US dollar – along with the assumptions for stimulus and risk trends that both carry – one side of this unbalanced equation was bound to give. Though it held out as long as it could, it was the greenback that cracked first. As dubious as the outlook for growth, income, earnings and yield are; the market is still positioning for higher yields (in other words ‘chasing yield’). Monday, the gap was forced close by a specific piece of event risk: the ISM manufacturing report for May. The 49.0 reading was the lowest in nearly four years and reflects a contraction for the same sector that led the US economy to its recovery back in 2009-2010. That could have been interpreted as a ‘risk negative’ outcome, but the restrained equity and futures showed investors weren’t going to be shaken from their trades on the read. On the other hand, the dollar was quick to react to the data with a selloff that began immediately after the data.

A distinct sign of what is most important to the market psyche now, despite the reserved reaction from equities to the factory activity report; the USDollar put in for an immediate tumble after the print. A reading that points to sputtering US growth supports the call for patience the majority of the FOMC officials called for when they said they wanted to see consistent strength in forthcoming data. It was unlikely that the QE3 taper would be announced in June before the data, but now it is likely viewed as a certainty. The dollar can ease back further should the trade report, NFPs or Fed speeches further squash such speculation. However, don’t forget that general risk aversion can also drive the dollar higher…

Japanese Yen, Nikkei 225 and Capital Spending Defy Abe
There was little support from the markets and economic docket to support the efficacy of the Japanese government’s and central bank’s influence over the economy and financial system. Monday, the yen advanced a fourth consecutive day, the Nikkei 225 dropped another 3.7 percent and first quarter capital spending dropped another 3.9 percent through the first quarter. All of this contradicts the efforts policy officials are putting forward. Yet, we shouldn’t take this as the definitive assessment of whether ‘Abenomics’ will be successful or not. Particularly for the markets, moderation after the preceding run up is reasonable. Meanwhile, the BoJ reported the monetary base posted its second fastest pace (31.6 percent) in four decades – hitting an unprecedented ¥159 trillion. If the yen drops it won’t be due to the BoJ’s lack of trying.

Australian Dollar: Will the RBA Curb Aussies Best Rally in Nearly a Year?
The AUD/USD posted an impressive 2.1 percent rally Monday – the biggest daily advance since November 30, 2011. Part of this strength was owed to the US dollar’s own weakness, but a market-wide advance for the Aussie currency shows that there was a more complex fundamental backdrop. A slow climb since the early Asia session shows some reaction to the better-than-expected print for Chinese manufacturing activity on Saturday. Add to that the Australian manufacturing jump and first quarter corporate profit figures, and there was enough of a groundswell for a fundamental rebound. This morning, we have seen the current account deficit shrink further than expected (A$8.5 billion), yet that comes alongside news that foreign holdings of Aussie government debt hit a 3Q 2010 low – evidence of the diversification discussed previously. Coming up, the market is pricing in a modest 15 percent probability of an RBA 25bp rate cut. A hold would likely allow Aussie continuation.

Euro Balance of Growth and Austerity Tipping Once Again
The Euro dropped against most of its counterparts – with the notable exception of EURUSD advance. The docket held the second round reports for Euro-area manufacturing activity, but the improvements hardly negated recession fears. Far more interesting were headlines like Fitch’s downgrade of Cyprus (they upgraded Greece two weeks ago) and news that German Chancellor Merkel was backing away from an open-ended growth support for Europe. We will learn more when the Finance Minister speaks at his CDU election platform discussion.

British Pound: BoE Reports Borrowing Recedes, Rescue Effort Ineffective
Are financial and economic conditions in the UK improving enough to negate Bank of England intervention? According to the central bank, financial firms in the region borrowed £300 million less from the Funds for Lending Scheme (FLS) through the first quarter. However, this is hardly evidence of improved financing and rather reflects shrinking demand. The BoE rate decision is due Thursday.

Canadian Dollar: USD/CAD Drops Back Below 1.0300 Before Trade Data
While the Canadian dollar suffered at the hands of its higher-yielding counterparts and was a mixed bag elsewhere, USD/CAD’s slump back below 1.3000 certain improves the loonie’s bearing in the FX market. A confidence in stimulus for risk and US economic support is a Canadian dollar positive. Coming up, we will see if the region’s trade report can generate some domestic strength.