And Now, A Word From Your Central Bank

Federal Reserve Chairman Ben Bernanke's testimony on Capitol Hill triggered wild intraday swings in the currency market. By the end of the North American session however, the dollar settled not far from where it traded before the release of Bernanke's prepared testimony. Unfortunately the Fed Chairman created more confusion than clarity for investors but avoiding a one directional reaction could be his intention. The main takeaway from Wednesday's speech is that while Bernanke is in no rush to raise interest rates and he still plans to taper asset purchases this year, he understands the need to carefully manage market expectations and to reassure investors that any decision will depend on data. So while the pace of bond purchases is not on a preset course, the central bank is still looking to taper QE in 2013 and halt it around mid-2014.

Bernanke had two goals going into the speech -- #1 - avoid driving Treasury yields sharply higher and #2 - explain to Congress that a reduction in stimulus does not equate to tightening. Based on the drop in U.S. Treasury yields and the fact that the dollar and stocks ended the day virtually unchanged, his goals were achieved. To stress how serious he is about disconnecting tapering with tightening, Bernanke even said that the economy "would tank" if the Fed were to tighten monetary policy. By failing to harden their commitment to tapering in September, the Fed Chairman gave FX traders very little reason to buy dollars. While we still feel that the greenback is headed higher in the long run, one important possibility is consider is that when the Fed tapers it may not be the start of a series of reductions. We know that Bernanke wants to see a more dramatic improvement in the labor market and more consistency in data and for this reason, "bond purchases could be reduced more quickly if conditions improve faster or maintained longer if conditions are less favorable."

FOMC voter Stein who is normally one of the more dovish members of the FOMC appears to be on board with the idea of tapering when he said low rate policies are difficult for retirees who may rely on yield for return on their savings. Fed President Raskin, on the other hand, avoided providing any direct views, choosing instead to say that Fed policy will be data dependent. Housing starts and building permits plunged, a sign of potential setback in the market. Nonetheless according to the Beige Book report, the U.S. economy grew at a modest to moderate pace with consumer spending and auto sales gaining in most districts, hiring steady or increasing at a measured pace and housing growing at a moderate to strong pace. Overall the Beige Book report was optimistic, which supports our view that the Fed is still on track to taper this year. Jobless claims, the Philadelphia Fed Survey and leading indicators are scheduled for release tomorrow.

GBP Soars As BoE Preps For Guidance
The British pound traded higher against all of the major currencies Wednesday on the back of positive economic data and less dovish BoE minutes. U.K. jobless claims dropped by 21.2k in June, the largest decrease in more than three years. This brought the claimant count rate down to 4.4% from 4.5%, its lowest since February 2009. However the primary catalyst for sterling's rally were the BoE minutes. First, the committee voted 9-0 to keep policy unchanged. Back in June at Mervyn King's last meeting, three monetary policy makers (King, Fisher and Miles) voted in favor of a GBP25 billion increase to the asset purchase program. On the surface, this left the central bank less dovish and explains the rally in sterling. However, these members altered their votes because the BoE is gearing up for a major change in guidance when they release their Inflation Report on August 7. New BoE Governor Mark Carney is certainly making his presence and influence felt by shaking up BoE policy so quickly into his term. Most likely, the BoE will adopt threshold guidance similar to the Federal Reserve. As for the two members who voted for more QE, according to minutes, they did not feel that it was sensible to support an expansion as other options are being investigated this month, which suggests they expect a significant change to come. Of course, it is important to remember that guidance does not equal tightening or easing, just more transparency and clarity on policy. The focus will remain on sterling over the next 24 hours with U.K. retail sales scheduled for release. Despite the improvement in the labor market, lower shop prices and a decline in the BRC retail sales monitor points to slower spending in the month of June.

CAD: BoC Adjusts GDP Forecast And Statement
It was a mixed day for the commodity currencies with the Canadian dollar weakening against the greenback, the New Zealand dollar strengthening and the Australian dollar unchanged. In his very first monetary policy meeting as Bank of Canada Governor, Stephen Poloz left his mark on the accompanying statement. For the past few months under Mark Carney, the BoC said a "modest withdrawal will likely be required, consistent with achieving the 2 percent inflation target." Poloz adjusted this language to say that "over time, as the normalization of these conditions unfold, a gradual normalization of policy interest rates can also be expected, consistent with achieving the 2% inflation target." The conditions he refers to include the amount of slack in the economy, the inflation outlook and household sector financials. In outlining the terms, Poloz has provided more guidance and clarity on monetary policy. So while there were no major changes in bias, we now have a better sense of what the BoC is looking at. The central bank left interest rates unchanged at 1% and altered their 2013 and 2014 forecast. They now expect the economy to grow by 1.8% in 2013 compared to a prior forecast for 1.5% growth but in 2013, they expect growth to be 2.7% compared to a 2.8% forecast. Low rates still remains appropriate for the time being because slower growth in China is a new risk for Canada. In the end, the main takeaway from the BoC announcement is that the central bank is in no rush to raise rates. Down Under, Australia's Westpac Leading Index dropped to 0.2% in May from 0.7%. Consumer confidence was scheduled for release Wednesday evening along with Business Confidence and the Conference Board's Leading Indicator report. While we feel that the risk for the data is to the downside, healthier numbers would drive a bigger short squeeze in the AUD.

EUR: Italy Slashes 2013 GDP Growth
With no major euro-zone data released, the euro took its cue from the dollar throughout the North American session. The only news that we had was from Italy, where the Bank of Italy cut its GDP forecasts significantly. They now expect growth to contract by -1.9% compared to a prior forecast of -1.0% with modest growth of 0.7% expected to return in 2014. The downgrade was motivated by their concerns about the global economy, liquidity conditions for companies and credit supply. Unfortunately they see no improvement in the labor market with the rate of unemployment expected to rise from 12% in 2013 to 13% in 2014. Weak growth throughout the region is a problem that the ECB will struggle with this year and a reason why they are keeping monetary policy easy. Euro zone current account numbers are the only piece of EZ data scheduled for release Thursday and the impact on the EUR should be nominal. Trade numbers from Switzerland are also scheduled for release with the country's surplus is expected to trickle slightly higher.

JPY: BoJ Minutes Show Internal Divergence
The Japanese Yen traded lower against all of the major currencies. Last night's Bank of Japan meeting minutes revealed a divergence in views within the central bank. A few members felt that that longer dated fixed rate funds in market operations were necessary to reduce volatility in the financial markets but the majority were worried that the action would be misinterpreted by investors, causing even greater volatility for the Nikkei and JGBs. Central bank officials did not want the market to interpret any action as a change in monetary policy strategy when it would only be an attempt to reduce volatility. Their decision to stand pat turned out to be the smart one because the volatility in Japanese markets settled without BoJ support. Nationwide and Tokyo department store sales are the only pieces of Japanese data that were scheduled for release Wednesday evening and, given the BoJ's optimism, both are likely to increase.

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