USD Soars Ahead Of FOMC

On Monday we saw how much of a difference a few hours can make with the dollar recovering earlier losses to end the North American session higher against most of the major currencies. With only two days to go before the Federal Reserve's monetary policy announcement, the big move in equities and the reversal in currencies suggests that traders are beginning to position for FOMC. Yet taking a look at how the various markets are trading, there seems to be more confusion than clarity on what the central bank will say or do. The rise in the dollar and the increase in U.S. Treasury yields imply that currency and equity traders believe that the main takeaway from this week's meeting will be that the central bank is gearing up to taper. However the rally in U.S. equities suggest that stock traders believe that the Fed will make a point to distinguish tapering from tightening and reassure investors that cheap and easy money will remain available for a very long period of time. If Bernanke is successful in convincing the market that they will take a very gradualist approach to tapering, the U.S. dollar could give up its gains. However if Bernanke emphasizes the central bank's plans for tapering over its difference with tightening, the dollar could extend its rise.

It won't be an easy conversation for Bernanke to have and with a press conference scheduled he will have to answer some tough questions from reporters. The Federal Reserve is widely expected to lower its inflation and GDP forecast because growth and price trends are weaker than what the Fed anticipated back in March. Nonetheless, we continue to see gradual improvements in the U.S. economy. For example, according to the Empire State survey, which rose from -1.43 in May to a three-month high of 7.8 in June, manufacturing conditions in the NY region recovered after pulling back last month. This may only be one piece of early U.S. data but it provides hope for the U.S. economic outlook. U.S. consumer prices, housing starts and building permits are scheduled for release Tuesday. Inflationary pressures are expected to tick up slightly due to higher gas prices but housing starts and building permits are expected to reverse some of the past month's changes. Starts fell sharply in April and are therefore expected to rebound in May but permits are expected to fall after soaring the month prior. Overall, low rates in the U.S. are supporting the housing market so no major downside surprises are expected in Tuesday's report. In the meantime speculation about the possible outcome of the Fed Meeting will dominate financial market moves leading up to Wednesday's FOMC announcement.

EUR: Unclear How ZEW Survey Could Fare
The euro ended the day slightly higher against the U.S. dollar, recovering earlier losses near the end of the NY session. The region's trade surplus shrank to 14.9 billion euros from 22.5 billion euros on weaker trade activity in Germany and France. Month over month exports declined and imports increased despite the drop in energy imports. While the softer trade balance prevented the euro from rising, the impact on the currency was limited. Instead, Tuesday's German ZEW survey of investor confidence should have a more significant impact on the currency. Economists are looking for a small uptick in sentiment because more recent economic reports have shown gradual improvements in the region's economy. However with the recent volatility in the financial markets, we would not be surprised if investor sentiment remained unchanged or deteriorated. Meanwhile between the G8 Summit, euro area finance ministers meeting and EU finance ministers meeting, we can expect a number of comments from European officials. ECB President Draghi speaks Tuesday but he may not touch on monetary policy because the speech is at a farewell conference for the Bank of Israel Governor. The last time we heard from Draghi he said Germany's biggest export market "should stabilize and recover in the course of the year, albeit at a subdued pace" this year but there may be less domestic and global demand for euro-area goods." The focus for Europe this week will be Thursday's PMI reports but the ZEW survey can also cause some volatility for the euro.

GBP: Still Testing 1.57, All Eyes On CPI
The British Pound ended the North American trading session virtually unchanged against the U.S. dollar and euro. The only piece of U.K. data released over the last 24 hours was house prices and according to the report, prices rose 1.2% adding to a sixth consecutive month of increase. The survey taken by Rightmove revealed that "the national average asking price of a property coming to a market is over a quarter of a million pounds for the first time." Rightmove believes that higher confidence, lower mortgage rates and prices affected by inflation promoted additional housing market activity. In the survey it says, "Property market recoveries are traditionally led by London and, belatedly, the trend set in the capital now appears to be spreading as a broader housing market recovery is potentially on the cards." The Bank of England's Funding for Lending Scheme and the government's Help to Buy Scheme have helped improve housing market activity by making loans easily assessable. Inflation reports are scheduled for release Tuesday. Consumer prices are expected to grow at a slower pace but on annualized basis, CPI is expected to hit 2.6%, up from 2.4%. According to the British Retail Consortium, shop prices declined last month, which confirms that inflationary pressures declined. Weaker CPI could stall the GBP/USD rally ahead of the BoE minutes and Thursday's retail sales report.

AUD: What To Expect From RBA Minutes
It was a rollercoaster ride for the commodity currencies, Monday, which rallied in the early U.S. hours, declined during the day only to squeeze higher towards the end of the NY session. This volatility suggests that currency traders are not convinced that the outlook has improved enough for risk currencies to rally. Mitsubishi's decision to suspend its $5.9 billion iron ore project in Australia may have contributed to the AUD/USD decline but hardly explains the intraday reversal in the NZD and the CAD especially since Canadian and New Zealand data was good. Foreign purchases of Canadian denominated securities hit a seven-month high in April. With Canadian data continuing to improve and oil prices extending higher in June, we suspect that foreigners have boosted their exposure to Canadian even further. In New Zealand, consumer confidence increased in the second quarter and service sector activity held steady after being revised higher in April. The minutes from the most recent Reserve Bank of Australia monetary policy were due out Monday evening. If you recall, when the central bank last met, they refused to drop their bias to lower rates choosing instead to say that while the exchange rate has depreciated, "it remains high considering the decline in export prices." A day later, we learned that GDP growth slowed to its weakest level since 2011, which may explain why they left the door open to lower rates. The RBA minutes are therefore expected to remind the market about the central bank's level of dovishness which could translate into additional losses for the Australian dollar.

JPY: G8 Summit And Abenomics
The Japanese Yen traded lower against nearly all of the major currencies as the recovery in Japanese and U.S. stocks lifted risk appetite. The G8 leaders Summit is underway and while the civil war in Syria is on the top of the agenda, Prime Minister Abe is expected to be asked a variety of questions on Abenomics but we don't expect anything specific to be included in the communiqué. Previously, some leaders felt that Japan was deliberately weakening its currency but with the Japanese Yen appreciating more than 9% since the middle of May, Abe could easily point to the move and say that their accusations are not true. As a result, we don't expect the G8 Summit to have a dramatic impact on the Yen. According to the CFTC's Commitment of Traders report released on Friday, speculators are still very net short yen. While the data was as of June 11 when USD/JPY ended the day at 96, we doubt that positioning has changed that much since then. The data suggests that speculators still feel that Abenomics will weaken the Yen and until some of those short positions turn into longs, the Bank of Japan will be hesitant about intervening in the currency. The latest Japanese economic reports show continued improvements in Japan's economy. While the Tertiary activity index fell short of expectations, the number terrible isn't when taking the sharp upward revision to the last month's report into consideration. Condominium sales in Tokyo also jumped 49.2% year over year. Industrial production and Machine Tool orders were scheduled for release Monday evening but as final reports, they are not expected to have a major impact on the Japanese Yen.

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