How Traders Are Positioned Ahead Of Bernanke Testimony

EUR: Rally Masks Underlying Weakness
GBP: Consumer Prices on Tap
CAD: Will be Difficult for BoC to Remain Hawkish
AUD: RBA Minutes On Tap
NZD: Slower Service Sector Activity
JPY: Lifted by Risk Aversion

How Traders Are Positioned Ahead of Bernanke Testimony

The Federal Reserve Chairman's semi-annual testimony on the economy and monetary policy is always an important event for the market. It is an opportunity to get into the mind of the central bank and with a long question and answer session, Bernanke will have to craft his words carefully to avoid dropping any unintended hints on monetary policy.

Not all testimonies before the Senate and House are big market moving events, but in this case we are at a critical juncture in monetary policy and the market is split on whether additional action will be taken by the Fed. As a result, every word that Bernanke says and doesn't say could have major implications for the market and for this reason he will choose his words carefully.

Yesterday's sell-off in the U.S. dollar and U.S. equities tells us that investors are positioning for slightly more dovish comments from Bernanke. Surprisingly weak retail sales numbers in the month of June reinforced the deteriorating conditions in the U.S. economy and hardened the case for QE3. However, outside of overtly signaling the possibility of more stimulus there's not much Bernanke can say or do that he hasn't already.

When he last spoke, the Fed Chairman openly admitted that they were too optimistic about growth and warned that further steps could be taken if there are no improvements in the labor market. To remove any ambiguity, he went on to say that those steps could include "additional asset purchases."

By repeating these words, he would reinforce the central bank's dovish monetary policy stance without hinting at any new action - for investors this may not be enough. However if Bernanke does surprise the market by signaling plans for QE3, we could see a much stronger rally in the EUR/USD because according to last week's CFTC IMM report, short EUR/USD positions remain at very elevated levels. For more on where we believe Bernanke will stand on QE3, read The Most Realistic Timing for QE3 and Its Impact on the U.S. Dollar.

The latest weakness in the U.S. dollar was triggered by the retail sales report. Economists were looking for retail sales to rebound in June but instead consumer spending declined for the third consecutive month. Despite the rebound in stocks last month, the uncertainty in the global economy and the high level of unemployment has kept consumers out of the stores.

While non-store retailers saw a 0.5% increase in sales, spending in general dropped 0.5% and excluding autos and gas, retail sales declined 0.2%. In all, this was a very ugly retail sales report. There was broad based weakness in spending but the largest drop off was in demand for sporting goods, spending on building materials, gas stations and department stores.

With 3 back-to-back months of negative retail sales growth, we are looking at a very weak third quarter GDP that will show minimal improvement in growth. The Empire State Manufacturing index rose to 7.39 from 2.29 in July but this uptick in NY manufacturing conditions will be lost amongst the weak retail sales number.

Aside from Bernanke's testimony, we also have consumer prices, the Treasury International Capital Flow Report, and industrial production scheduled for release today.

EUR: Rally Masks Underlying Weakness

The euro rebounded strongly against the U.S. dollar to end the day yesterday near its highs. The rally in the euro had nothing to do with the outlook for the Eurozone because the EUR/USD was trading in negative territory before the U.S. retail sales report.

European stocks ended the day virtually unchanged while Italian and Spanish bond yields edged higher. According to the latest reports, Eurozone consumer prices fell 0.1 percent in June which means that inflationary pressures are nonexistent, giving the European Central Bank plenty of room to ease again if necessary.

The Eurozone trade surplus increased in May from EUR4.5B to EUR6.3B but this was only after a major downward revision to the prior month's report. The biggest story out of Europe yesterday (aside from the ongoing LIBOR scandal) is reports that the ECB supports imposing losses on senior bondholders of Eurozone banks. The Spanish economic minister and Ireland's economic ministry deny that the ECB holds this view, but with the memorandum of understanding outlining the terms of Spain's bank bailout expected to be signed on July 20th, rumors are swirling.

If true, this would make senior bondholders vulnerable to losses, which would be a major shift in ECB strategy that could make European investments less attractive. The German ZEW survey is scheduled for release today, Tuesday, and given the troubles in Spain, investor confidence is expected to have deteriorated.

GBP: Consumer Prices on Tap

The British pound traded higher against all of the major currencies despite a sharp decline in house prices in the month of July. According to Britain's largest property website Rightmove, house prices dropped 1.7 percent in July due to the increase in supply.

While the market's focus was on the U.S. dollar yesterday, this is also a big week for the British pound. U.K. consumer prices are scheduled for release today, and given the drop in producer prices and lower shop prices reported by the British Retail Consortium there is a strong possibility that consumer price growth eased in June. In fact, as an inflation targeting central bank, the Bank of England would have had a tough time justifying their increase in asset purchases earlier this month if CPI ticked higher.

However, the CPI won't be the only opportunity for us to get a sense of what the Bank of England is thinking. The minutes from the most recent central bank meeting, retail sales and jobless claims are among the other pieces of data expected out of the U.K. this week.

CAD: Will be Difficult for BoC to Remain Hawkish

While the Canadian dollar ended the day lower against the greenback yesterday, it recovered a large part of its earlier losses, which suggests that some traders are banking on the Bank of Canada remaining hawkish today. The last time the BoC met in June, they said. "to the extent that the economic expansion continues and the current excess supply in the economy is gradually absorbed, some modest withdrawal of the present considerable monetary policy stimulus may become appropriate." This was a slight downgrade from the prior month's monetary policy statement but still considerably more hawkish than the market had anticipated given the economic data.

The Bank of Canada faces most of the same problems this month - economic data has taken a turn for the worse with manufacturing activity contracting, job growth slowing and inflationary pressures easing. Growth in the U.S., Canada's largest trading partner has also ground to a halt which does not support the case for stimulus withdrawal.

As a result, we expect the BoC to move to neutral, which could shave some gains off the CAD. The Australian and New Zealand dollars on the other hand edged higher. Service sector activity in New Zealand slowed slightly according to the PMI report. New Zealand consumer prices are due for release this evening followed by the minutes from the most recent RBA meeting.

JPY: Lifted by Risk Aversion

The Japanese Yen strengthened against all major currencies yesterday. USD/JPY fell to a fresh 1 month low following the U.S. retail sales report. Asian stocks rose after China's Premier Wen Jiabao provided cause for optimism to investors by saying China will increase measures to support growth in the world's second largest economy. Gains in stocks were limited however due to the fear of declining profits for Asian companies. Chinese growth slowed to its weakest level since 2009 in the second quarter. The Nikkei 225 Index rose 0.05% to 8,724.12.