If You're Trading USD, Know This

3 Things Traders Should Know About The Dollar

The U.S. dollar performed extremely well this week as investors and traders around the world continue to position for a change in monetary policy. A little more than a week ago, Federal Reserve Chairman Ben Bernanke kicked off a fresh rally in the dollar by saying that asset purchases could be tapered in 2013. His views were reinforced this week by other voting members of the FOMC and their comments drove the dollar to fresh highs against all of the major currencies. The greenback rose to its strongest level against the Australian dollar in 2.5 years and its strongest against the Canadian dollar in more than a year. While we did not see the dollar reach milestones as significant as these against the euro, Japanese Yen and British pound, the greenback still rose to a more than three-week high against all three currencies.

Going into the new shortened trading week (U.S. markets will be closed for the July 4th holiday), there are three things that forex traders should know about the dollar:

1. The Fed will most likely taper in September: Despite all of the attempts by FOMC voters this week to downplay the significance of Bernanke's comments by saying that the decision to taper will be based on data, Fed President Stein was quite clear that September could be the month when changes are made. Stein said, the Fed should "be clear that in making a decision in, say, September, it will give primary weight to the largest stock of news that has accumulated since the inception of the program and will not be unduly influenced by whatever data releases arrive in the few weeks before the meeting." This specific comment about September sparked speculation that it will be only two more months before the Fed starts to taper, which we agree is likely because the central bank will not want to suddenly reduce stimulus right before the holidays. While we have already seen the dollar trade higher on liquidation of dollar funded carry trades and re-pricing of FOMC expectations, there's scope for further gains on next week's economic reports.
2. The Sustainability of Dollar Gains Hinge on Next Week's Data. A number of U.S. economic reports are scheduled for release next week including manufacturing and non-manufacturing ISM and the ever important non-farm payrolls report. A minor slowdown in job growth is expected to be offset by a drop in the unemployment rate. The closer the unemployment rate gets to the 7% mark mentioned by Bernanke and Stein, the greater the likelihood of a reduction in stimulus in September instead of December. As long as there aren't any major disappointments in U.S. data, we expect the dollar to extends its gains in the coming week.
   
3. President Obama Looking to Replace Bernanke. Finally talk of a replacement for Bernanke could gain momentum in the coming weeks. According to the Wall Street Journal, Obama already has a short list of candidates that most likely includes Janet Yellen, Tim Geithner and Larry Summers. The role of Fed Chairman is a very important one as this person's background, experience and monetary policy bias will play a role in how he or she handles the recovery and future crises. If Bernanke settles on a candidate that the market is less familiar with, the uncertainty could add pressure on equities and currencies.

EUR: Don't Expect Any Help from Draghi

Ahead of the European Central Bank monetary policy announcement, 1.30 appears to be rock solid support for the EUR/USD. The currency pair tested and held this level for three consecutive trading days thanks in part to better than expected economic data. German retail sales rose 0.8% in the month of May and consumer spending in France increased 0.5%. Consumer appetite is recovering after contracting the previous month, which is good news for the euro zone. Earlier this week, we also saw an improvement in German labor market conditions. Unfortunately these stronger reports helped to stabilize the euro but did not rally it. This is due in part to concerns about next week's ECB meeting. With inflationary pressures growing at a slower pace according to the latest German CPI numbers, the ECB has plenty of room to keep monetary policy easy. Generally speaking, the recovery in the euro-zone economy is still very uneven and this should encourage the ECB to maintain an easing bias. We firmly believe that when ECB President Draghi holds his press conference next week, he will repeat that the central bank stands ready to act if necessary. Unlike the Federal Reserve, the Europeans are not even thinking about reducing stimulus at this time.

GBP Slips Despite Stronger Confidence And House Prices

The British Pound weakened against the euro and U.S. dollar despite an improvement in consumer confidence. According GfK consumer sentiment rose to its highest level in two years as the survey index improved to -21 from -22. While the economy is showing signs of recovery after resuming growth in the first quarter, data yesterday revealed that disposable income fell the most in 26 years. GfK said, "The overall trend in confidence over the last year is clearly upwards. So the paradox is that while we are getting worse and worse off, we are feeling more positive." Bank of England Governor Mervyn King said earlier this week that a recovery "is in sight" but is "too weak to be satisfactory." Nationwide Building Society reported that house prices increased at the fastest pace since September 2010. Prices rose 1.9% year-over-year from 1.1%. Month-over-month, prices rose 0.3% in June compared to 0.4% in May. Nationwide noted that signs of economic recovery improved buyer sentiment. Nationwide said, "Demand for homes has been supported by further modest gains in employment, as well as an improvement in the availability and a reduction in the cost of credit, partly as a result of policy measures, such as the Funding for Lending Scheme."

AUD: Potential Test Of 90 Cents

Broad based U.S. dollar strength drove the Australian and New Zealand dollars sharply lower against the greenback Friday. The AUD/USD broke below its prior 2.5-year low of 0.9148 intraday, making 0.9114 the new key level to watch in the currency pair. There were no major economic reports from Australia or New Zealand but the continued unwind of dollar funded carry trades and concerns about the outlook for China weighed heavily on both currencies. Next week will be a very busy one for the Australian dollar with PMI, retail sales and the Reserve Bank of Australia monetary policy meeting on the calendar. In addition to these Aussie specific event risks, China will also be releasing its official manufacturing and non-manufacturing PMI reports. We expect the Reserve Bank to remain dovish and if this sentiment is accompanied by weaker Australian or Chinese economic reports, the AUD/USD could test 90 cents. The Canadian dollar also lost value against the greenback on the heels of softer GDP numbers. The Canadian economy expanded by 0.1% in the month of May compared to 0.2% in April. This slowdown in growth dragged the year over year number down to 1.4% from 1.7%. While these figures are very dated, the lack of momentum in economy at the beginning of the second quarter should limit the optimism of the BoC.

USD/JPY Supported By Recovery In Nikkei

The Japanese Yen traded lower against all of the major currencies with the exception of the AUD. Having closed above 98 for the first time in two weeks yesterday, USD/JPY extended its gains above 99, putting the 100 level in reach. Last night was a very busy one in Japan with the release of a heavy dose of mixed economic data. According to our colleague Boris Schlossberg, "The latest releases showed that unemployment ticked up to 4.1% from 4.0% eyed, household spending contracted sharply to -1.6% versus 1.4% and inflation saw little pick up with National CPI at 0.0% versus 0.0%. There were however some bright spots as Retail Trade increased markedly to 0.8% from 0.2% forecast and Industrial Production improved as well. Overall the market took heart from the gradual improvement in activity in the corporate sector reasoning that an increase in profits will eventually translate into broader consumer demand." Fixing demand for new toshin funds also helped to lift USD/JPY. In the new trading week, we will be keeping a close eye on the Nikkei. If Japanese stocks continue to recover, USD/JPY could extend its gains. The outlook for stocks will hinge in part on Sunday's quarterly Tankan report, one of Japan's most important economic releases. If business confidence continues to improve, the Nikkei could extend its gains.

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