FX Week In Review: Focus On The Dollar

It has been a great week to be long U.S. dollars. The greenback traded higher against all of the major currencies as investors around the world grew more attracted by the performance of U.S. equities and the rise in Treasury yields. The S&P 500 climbed to fresh record highs Friday, extending a move that has taken the index up 7.5% over the past month. During this time, 10-year U.S. Treasury yields also rose from 1.7% to 1.95%. With U.S. equities performing so well and Treasuries offering an increasing yield, the dollar attracted significant demand but just how well has the greenback performed? The dollar index is up 2% over the past month, which doesn't seem to be a lot but when looking at some of the individual currencies, we see just how far the dollar has come. The following chart shows how G10 currencies have performed over the past week and month. The Australian dollar is the worst performer and surprisingly the euro dropped the least against the greenback. The scorecard for the past month looks about the same except the EUR dropped to number two in terms of smallest losses with GBP taking the number one spot. This makes sense because the U.K. economy is in recovery mode whereas the euro zone is in recession.

With only consumer confidence expected from the U.S. this morning, it was suppose to be a dull and quiet trading day but it is these uneventful sessions that have seen key levels broken in very big ways in the forex market. The dollar index rose to its highest level in almost three years as EUR/USD breaks 1.28 and USD/JPY hit new highs above 103. Consumer confidence soared in the month of May according to the University of Michigan survey. The index jumped from 76.4 to 83.7 reaching the highest level in nearly six years. The record setting performance of U.S. equities and the improvement in the labor market has made Americans feel more optimistic about the outlook for the U.S. economy. Even with the disappointments in data seen over the past week, the persistent rise in U.S. bond yields and outperformance of U.S. equities has made the dollar extremely attractive to global investors. With the Federal Reserve talking about tapering asset purchases at a time when European officials are considering more aggressive monetary easing measures such as negative deposit rates, investors are buying dollars because they can't see better opportunities. The monetary policies of the ECB and the BoJ pose a threat to the value of the EUR and JPY whereas the next move by the Fed should support the dollar. Capital preservation is just as important as capital appreciation these days. Next week's FOMC minutes will particularly to the outlook for the dollar because we will get greater insight on whether talk of asset purchases gained momentum at the last meeting.

USD/JPY Breaks 103
USD/JPY hit a new four-year high on the back of better than expected U.S. data and rising U.S. bond yields. While all of the Japanese Yen crosses benefitted from USD/JPY demand, the losses experienced in the AUD, NZD and CAD prevented those pairs from gaining strength against the Yen. Last night's Japanese economic reports showed continued improvements in Japan's economy but it was U.S. strength that drove the currency pair to fresh highs. As we mentioned before, USD/JPY traders need to keep an eye on U.S. yields. The following chart shows how the latest rise in U.S. yields gave USD/JPY the catalyst it needed to push higher. The Bank of Japan meets next week and with economic data showing gradual improvements and the Yen falling to fresh lows, no changes to monetary policy are expected but comments from the central bank could still affect how the currency trades.
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EUR/USD Resilience
While the euro also fell victim to dollar strength, its decline was modest compared to other major currencies. The performance of the euro is surprising given the amount of focus on ECB policy and the euro-zone recession. There are a few possible explanations for the currency's resilience but most of them are fleeting at best and we ourselves could come up with a host of counterarguments. The first possible reason is that stocks have performed well and as a risk currency, the euro is seeing some benefit from the move. Yet if that was true, the GBP and AUD would not have ended the day near its lows. Second, the recent decline in the euro will pay off in the long run but we all know that FX traders don't have such a very long attention span. The third explanation is positioning. According to the CFTC's Commitment of Traders report, speculators have been gradually increasing their EUR/USD short positions but that argument is also weak as euro shorts are far from extreme levels. Finally, we believe that the real reason why the euro refuses to fall is the least headline grabbing one and that is due to the existence of stops and options expirations at each round number level. We saw that it at 1.30, 1.29 and now 1.28. Looking ahead, we have a very busy economic calendar for the euro zone next week that includes the monthly PMI numbers and the German IFO report. These releases will determine whether euro extends its losses or stabilizes above 1.28.

AUD: Extends Losses As Gold Moves Lower
The Australian, New Zealand and Canadian dollars have been hit the hardest by U.S. dollar strength. The 2% drop in gold prices drove the AUD and NZD to fresh lows while the CAD shrugged off the rise in oil prices choosing instead to react to the decline in consumer prices. Traders have been selling the comm dollars mercilessly despite the lack of new data. Next week's RBA minutes will help decide whether the AUD stabilizes or makes it way down to 95 cents. Our colleague Boris Schlossberg made some good points this morning. He said "The liquidation is driven by the assumption that the RBA will now embark on an easing cycle in order to stimulate the slowing Australian economy. However, as we pointed out yesterday the Australian economy appears to be more robust and flexible than initially thought. Furthermore, one of RBA's stated goals for its recent rate cut was to drive down the value of the currency, but the market having done the brunt of that work already, Australian monetary policy makers will no have less motivation to ease in the foreseeable future. One other factor driving the Aussie lower is the slide in precious metals and that may indeed continue to be a drag on the currency especially if Gold drops through the $1300/oz. barrier. But the correlation and dependence on Gold has weakened considerably for the Australian economy and the Aussie and therefore any further downside damage is likely to be capped. Meanwhile central bank reserve diversification traders are no doubt starting to bargain hunt at these levels and the pair could begin to stabilize as the last of the liquidation flows taper off. The Aussie is now coming into long term support at the 9700 level and could see some profit taking bounce over the next few days." The takeaway is not to forget that a weaker currency is stimulate for the economy and in the case of Australia could reduce pressure on the RBA to ease again.

GBP: Big Week Ahead
With no U.K. economic data on the calendar, the British pound traded lower against the U.S. dollar and euro. This week we have seen further improvements in the U.K. economy and a GDP upgrade from the Bank of England. More economic reports are scheduled for release next week including consumer prices, retail sales, the minutes from the last BoE meeting and GDP. Each and every one of these reports has the power to cause big swings in the GBP and collectively could drive a breakout move in the currency. We still feel that more gains than weakness are likely in the GBP after recent data surprises. Considering that the last central bank meeting occurred after the April PMI numbers were released, we expect less concern about the outlook for the U.K. economy. If you recall, service, manufacturing and construction sector activity all improved last month. If we are right and the BoE sounds less concerned, sterling could recover its losses and head higher from there.

Lien, Managing Director of FX Strategy for BK Asset Management.