Dollar Lower As Fed Speculations Continue, Critical Weeks Ahead

Dollar depreciated broadly last week as markets continued to gauge the chance of Fed's tapering in September. A number of Fed officials spoke and it seemed like most would accept scaling back the asset purchase. In particular, the known dove Chicago Fed Evans also didn't rule out September tapering even though he sounded cautious. However, it should be noted that there have been speculations of lowering the $85b per month asset purchase pace by $20b. And based on the current set up data, risk leaned towards the side where Fed could delay the dial back, or with reduction small that $20b. Traders seemed to be closing up dollar long positions further. Treasury yields also dropped last week, together with a pull back in stocks.

Among the major currencies, Aussie gained most after a less dovish RBA statement and a string of positive economic data from China. Yen was the second strongest currency. Euro was the second weakest currency next to the greenback as pressured by selling in crosses against Sterling and Aussie. While dollar's weakness was broad based, it should be noted that EUR/USD is nearing critical resistance at 1.3416 and have been losing momentum. Traders should be cautious on a pull back in EUR/USD this week, which could trigger a broad based rebound in dollar. On the other hand, a strong break of 1.3416 in EUR/USD would likely accelerate the selloff on dollar against other major currencies. The greenback is at a critical juncture.

Looking at other currencies, Aussie rebound from a deep oversold level was impressive. But there is no clear indication of trend reversal yet. Yen's rally last week revived the case that yen crosses' rebound since June has completed earlier in July already. And, we'd favor more upside in the Japanese yen. Sterling outperformed Euro last week but we'd need to see sustained break of 0.8581 in EUR/GBP to confirm the underlying strength in the pound. Canadian dollar dropped against the greenback on weak job data. But we'd believe there is limited downside potential in USD/CAD.

Our strategy of EUR/AUD and EUR/CAD long were wrong last week as both crosses edged higher initially but dropped sharply since then. Based on the above analysis, we'd prefer to short yen crosses this week. And the preferred choices are USD/JPY and EUR/JPY. As we'd not sure whether EUR/USD would reverse below 1.3416 as we expect, we'd short both USD/JPY and EUR/JPY as some form of a hedge.

To recap some of the events, an ECB survey published today showed that economists are expecting deeper contraction in the Eurozone economic in 2013, by -0.6%, comparing to prior projection of -0.4% published a quarter ago. The report noted that the downward revision was due to weak domestic demand in the first quarter. Meanwhile, emerging economies like China and Brazil are expected to have lower contribution of net trade to growth in near term. 2014 growth is projected to be 0.9% and 2015 growth is projected to be 1.5%, both were downwardly revised from 1.0% and 1.6% respectively.

BoE made the largest change to the monetary policy framework since 2009 and linked the policy to unemployment rate, which was a surprise to the markets. BoE pledged to keep current policy unchanged at least until unemployment rate drops to 7%. And the MPC emphasized that 7% level is a "threshold", but not a "trigger". And, the sustainable rate would be well below that at around 6.5%. In the updated projections, BoE expects unemployment to fall from current 7.8% to 7.1% in Q3 of 2016, the end of its forecast horizon. That is, unemployment won't fall below the above mentioned 7% threshold. And BoE wouldn't probably raise rates until early 2017. However, it should be noted that BoE also gave itself an opt-out if inflation threatens to soar much higher than the 2% target. And the central bank could indeed tighten if medium-term inflation expectations stay above 2.5%. Markets took that as a sign that BoE is not ready to tolerate higher inflation. And currently, CPI in UK stands at 2.9%. Sterling rose sharply after initial knee-jerk reactions.

BoJ left policies unchanged as widely expected. Interest rate was held at near zero level while BoJ also maintained the pledge to expand the monetary base by JPY 60T to 70T a year. The increase in monetary base would be mostly through increase in government bond holdings by JPY 50T per annum. The accompanying statement noted that the economy is "starting to recover moderately" and "inflation expectations appear to be rising on the whole". Board member Kiuchi continued to propose to drop the two year inflation target and named is as a "medium- to long-term" target but was voted down 8-1. Overall, the statement gave no suggestion that BoJ would expand the policy stimulus in near term.

RBA cut rates by another 25bps as widely expected to 2.50% today. The statement was a bit less dovish then the prior one and was more neutral. RBA dropped the phrase that inflation outlook provided scope for further easing. Instead, the central bank noted that it will "continue to assess the outlook and adjust policy as needed". Regarding the economy, RBA noted that growth was a bit below trend over the past year. Inflation is expected to remain consistent with medium term target over the next one to two years. It expected recent rate cuts to have further effects over time. Meanwhile, the statement also noted while AUD has depreciated by around 15% since early April, further depreciation is possible. Overall, the statement didn't suggest further easing and the decision would be data dependent in near term. Later in the week, RBA lowered GDP projection to 2.25% in this calendar year, down from prior forecast of 2.5%. CPI is projected to rise 2.25% in the year to June 2014.

China Trade surplus narrowed to USD 17.8b in July. Exports rose 5.1% yoy, reversing the -3.1% yoy fall in June. Imports rose 10.9% yoy, also reversed the -0.7% yoy fall in June and -0.3% fall in May. The jump in imports were higher than market expectations and provided some evidence that the slowdown in China's economy has bottomed out. The data also raised hope that the economy would re-accelerate in the second half of the year.