Dollar Bull Trend Depends On EUR/USD, USD/JPY Reaction To Risk

How strong we expect the dollar to be depends on what we are measuring it against. If our benchmark is EURUSD, the pair has just this past week threatened to change directions on a seven-month bull trend. Alternatively, the Dow Jones FXCM Dollar Index (ticker = USDollar) is at its highest level in nearly two-and-a-half years with serious contributions from both USDJPY and GBPUSD. In a market where performance is relative, we need to pick the correct measure to establish just how strong or weak the benchmark currency is. We can do that by looking at various pairs, but we can also establish its strength by following its most influential fundamental drivers.

The most promising catalyst moving forward for serious dollar strength is a convincing change in risk appetite trends. Notably, the Dow Jones Industrial Average and S&P 500 both regained ground through Friday and ensured critical turning points (13,875 and 1,495) were left intact for the next bearish assault to second guess conviction. The FOMC minutes have started the conversation about a withdrawal of the unnatural stimulus backing, but it isn’t enough to fully withdrawal support and spark a deleveraging effort. In the week ahead, Fed Chairman Bernanke’s testimony in Congress will be digested and the sequester countdown will be fretted for the stimulus angle. Fear though, will be a market issue…

British Pound Hammered into the Close on Moody’s Downgrade
It was a fitting way for the British pound to end the week. Having taken the incredible dive below 1.5250 through the middle of the week – as the market recognized in the BoE minutes that there was a growing call to follow through with the stimulus speculators were projecting – it seemed like the bears had accomplished what they needed for the period. Yet, there was an incredible follow up to come in the closing hours of Friday when rating agency Moody’s announced that it had downgraded the United Kingdom from the top AAA rating down to Aa1. This was another serious aspect of fundamental depreciation for the currency: fear that the austerity-versus-recession balance would introduce an external factor that can disrupt the balance (in other words, a rate cut). Now we look ahead to determine whether there is momentum to be fed after the shock has set in. This development certainly changes the pound’s long-term health, but it has also depreciated sharply these past months.

Euro Finds Little Strength in LTRO2, Italian and Cyprus Elections AheadThere wasn’t much encouraging news for the Euro through the final 24 hours of this past week. Top headline was the announcement for the planned first repayment of the LTRO2 (second Long-Term Refinancing Operation) program loans. Though the €61.1 billion reduction continues to pull the ECB balance sheet down – while others like the Fed continue to add stimulus – it was much smaller than the consensus forecast. In other news, the EU downgraded its regional 2013 growth forecast for 0.1 percent expansion to a 0.3 percent contraction; and the Olli Rehn said further support for Spain would only come with evidence that the budget will stabilize. We will kick off next week with crowded newswires as investors interpret what the Italian and Cypriot elections mean for the euro. Through it all, remember, the ECB is shrinking its balance sheet.

Japanese Yen: Prime Minister Abe Plans to Hire Next BoJ Governor
Speculation surrounding the Fed’s eventual withdrawal of stimulus sometime before the end of 2013 was a modest boon for the yen crosses, as Japan’s more distant stimulus efforts seem more credible means for deflating the nation’s currency. Yet, relative gains through expectations that the Fed is moving to a tightening regime will lose momentum quickly. If the yen is too revive its five-month tumble, it will have to find an active catalyst. That may be difficult. Leveraging the carry trade through risk trends is highly unlikely given the turn in capital markets and fundamentals. Once again, it’s up to Japanese officials. If that is the case, the crosses will be looking very heavy. Prime Minister Abe may decide the next BoJ Governor next week, but actual policy change is highly unlikely to occur until the transition policy meeting.

Australian Dollar Has Accounted for Rate Outlook, Now it Needs Risk
There are two ways to move a currency when it comes to the influence of interest rates: you can either alter risk appetite levels (the demand for return) or you can alter a currency’s position on the yield spectrum. For the past month, the Aussie dollar has suffered on both fronts. However, interest rate expectations have arguably carried much of the performance. That said, RBA Governor Steven’s unflattering suggestion that the Aussie dollar was too high and that a cut would be the most likely move didn’t seem to unsettle AUDUSD. The balance of power is shifting over to actual carry deleveraging on risk aversion as the rate outlook for the Aussie dollar seems largely priced in barring a surprise rate cut.

Canadian Dollar Hits 8 Month Low Versus USD, GDP Figures Ahead
We’ve been distracted by the sterling, euro and greenback recently because of big ticket event risk. Yet, one of the most surprising performances has come from the Canadian dollar. The currency has fallen against most of its counterparts this past week and has notably encouraged a six consecutive day advance USDCAD. In turn, the pair has climbed to its highest level since June and is threatening to break congestion that dates all the way back to 2009. The loonie’s troubles were highlighted by a surprise trade deficit, easing house prices, a sharp drop in retail sales and inflation that is well below target. We will see how bad the situation may become with BoC’s Carney and GDP next week.