Dollar Carving Out Its Smallest Range In 15 Months Before Fed

The markets are showing an affinity towards either risk appetite or risk aversion. Instead, investor sentiment seems anchored; and sidelined speculative interest is showing through in the dollar’s performance. The Dow Jones FXCM Dollar Index (ticker = USDollar) has carved out its smallest five-day average true range (ATR) in two-and-a-half months. Perhaps better exemplifying the tension and hesitation in this market, Monday’s range for the Index was the smallest in 15 months (since April 11, 2011). If the speculative and fundamental backdrop were quiet / stable, we could attribute restrained activity levels to a general level of calm. However, we know that is the case. Economic and financial conditions have steadily deteriorated, while risk positioning has surprisingly grown. Anticipation of external support for the markets from prolific central banks has offered a tenuous balance to tangible decay. Now it is time to put this balance of hope to the test.

Since late 2008, in the wake of the Lehman Brothers collapse, the Federal Reserve has injected an incredible amount of support into the capital markets to promote growth and ensure financial stability. In fact, from September 2008 to its peak earlier this year, the central bank increased the size of its balance sheet by 225 percent (over $2 trillion) in its effort. This extraordinary effort with chaste intent, however, has created its own risk: moral hazard. Having grown acclimated to steadily rising capital markets and abnormally-low implied volatility (fear) levels, expectations for stimulus swell whenever turbulence and uncertainty rise. The deepening debt crisis for the Euro Zone and the slowing US growth engine seems to be enough of a signal for most to expect another round of support from the Fed.

There are a number of avenues that the world’s largest central bank can pursue, but the foundation of their decision is whether they will change any aspect of their program or not. We have to remember that they extended their Operation Twist program by $276 billion at the last meeting even though capital markets were buoyant and volatility levels were exceptionally low. In fact, their efforts have grown more and more reserved over time (from outright QE to extension of ‘duration extension’). Furthermore, there seems a growing concern within the Fed that newer programs have offered diminishing payoff. From a fundamental perspective, the economy is not threatening an immediate slip back into recession having printed 2Q annualized growth of 1.5 percent this past Friday. An outright asset purchasing program (Treasuries, mortgage-backed securities, or both) therefore is a low probability. There isn’t an immediate liquidity problem to justify a lending program through the discount window and lowering interest rates on excess reserves was questioned by Chairman Bernanke himself. What may be offered is an extension of the language for rates to remain low until ‘late 2014’ out to ‘mid-2015’, but that wouldn’t satiate high risk. If the Fed fails to deliver, the ECB’s position will be even more difficult come Thursday.

Euro: The Stakes for ECB Support Growing While Probabilities Fade

The euro rose across the board Tuesday despite a fading fundamental backdrop and growing skepticism surrounding the ECB’s intentions come Thursday. From the docket, the Italian unemployment rate jumped its highest level since 1999 and the Euro Zone’s jobless level hit a record (going back 22 years) high. As we recall the proposals that ECB President Draghi seemingly floated last week (possible rate cut, reactivate the SMP program, a new LTRO, supporting an ESM bank license) that market participants rallied around, reality that these agenda points are uncertain and that they ultimately won’t fix the underlying problem loom. Spain could use help of ECB bond purchases as the Bank of Spain announced it would delay its bank stress test until late September (hard to see this as a good sign). Meanwhile, Germany reminded the market that they wouldn’t support an ESM banking license even if Draghi did. In other news, the EFSF sold three-year notes at a highish 0.54 percent.

British Pound Slips Across the Board, 10 Year Gilt Yield Drops

Despite a strong performance by the Euro and the sterling’s connection its larger trade partner, the latter currency fell against all of its major counterparts. The official calendar offered only the BRC shop inflation report. More remarkable though was Moody’s lowered GDP forecasts for the UK (0.4 percent in 2012 and 1.8 percent in 2013) as well as the Stats office’s report that household income per capital hit a 2Q 2005 low.

Swiss Franc Advances Thanks to Euro Help, EURCHF Fight Weighing

The Swiss National Bank (SNB) released its mid-year report about its FX Reserve holdings composition. According to the central bank’s figures, their holdings of reserve assets have growth from 44 percent of GDP in December to 62 percent. Furthermore, the share of these holdings in euros accounts for 60 percent of the total. This suggests that not only is the EURCHF fight proving costly, they are struggling to diversify.

Canadian Dollar Struggles as May GDP Reading Falls Short

The Canadian Dollar struggled Tuesday, but the economic docket wasn’t likely the source of this malaise. The May GDP figuresreported a 0.1 percent pick up for the month and 2.4 percent pace of growth from the same period a year ago. This was modestly weaker than expected, but it doesn’t change the country’s relative investment appeal. So where was the weakness coming from: fear that the US may not find stimulus.

Australian Dollar Eases Back Before Risk-Influential Fundamentals

The Australian dollar was a mixed bag this past session, but the threat of heavy waves for risk trends through Wednesday’s Fed rate decision would work well to keep the currency anchored. On the docket this morning, the modest slide in the Chinese manufacturing PMI reading encouraged a slow pullback (still above 50). The Australian PMI reading was far worse with a 40.3 reading – the biggest slump since June 2009.