Dollar Plunged, Bernanke's Testimony Watched This Week

The dollar tumbled sharply last week after the confusing FOMC minutes and Fed chairman Bernanke's assurance that accommodative policies are here to stay for some time to come. The dollar index reversed after making a new 2013 high at 84.75, plunging to close at 82.94. The 10 year yield dropped in tandem with the greenback, but less deeply to close the week down at 2.601%. Stocks surged on the news, with the DOW closing at another record high of 15464.3. Gold recovered following the dollar's weakness to close at 1283.1, but found some resistance at the 1300 level. In the currency markets, the greenback lost ground against most major currencies except the Aussie which was sold off towards the end of the week. Markets are starting to price in another rate cut from the RBA in August. The yen was the strongest currency after BoJ left everything unchanged at the meeting. The major focus of the coming week will be Fed chairman Bernanke's semi-annual testimony to Congress.

Technically, the EUR/USD and GBP/USD formed short term bottom near to the 2013 low. The EUR/USD held above 1.2746, closing back above 1.3. The GBP/USD breached 1.4830 but rebounded to close above 1.51. The USD/CHF and USD/JPY were both limited below recent high dropped sharply. Note that both the EUR/USD and GBP/USD are limited well below key near term resistance of 1.3416 and 1.5751 so far. The USD/CHF and USD/JPY are staying in the recent range. There is no indication of trend reversal yet. Also, consider there the retreat in U.S. yields is also corrective looking. We'd expect some more sideways trading in the dollar, but the up trend would likely resume later.

Comparing the European majors, the euro has the upper hand against the sterling, but momentum is not apparent. It did, however, struggle to gain against the Swissy. Notable strength was seen in the EUR/AUD though, which made for an upside breakout. The yen was bound in range against the euro and Sterling last week, and the anticipated selloff didn't happen. But the AUD/JPY was clearly weaker and was the biggest mover last week. The Aussie clearly underperformed against other commodity currencies, with the AUD/CAD diving through the long term fibonacci level. The AUD/NZD also extended the larger downtrend.

Our strategy of the EUR/USD and GBP/USD shorts were incorrect last week, as both pairs rebounded strongly. As noted before, we're expecting more consolidative trading in dollar, and would thus avoid the greenback this week. Momentum in European majors were too apparent, both against other major currencies and among themselves, except versus the Aussie. Consequently, we'd avoid the European majors as well. The main theme would possibly be Aussie short this week. Based on anticipated weakness in yen crosses, we'd prefer to short AUD/JPY this week.

To recap, FOMC minutes for the June meeting sent a mixed message to the public regarding the Fed's QE tapering. At the minutes, it was unveiled that many of the policymakers did not believe that it would be appropriate to taper asset purchases at the moment. Yet at the addendum, it was indicated that almost half of the participants would like to pare the purchases later this year. Participants in the latter included non-voting members. Financial markets were lifted by the comments as it signaled the Fed might not begin tapering as soon as previously anticipated.

These two conflicting messages have made the outlook of the Fed policy stance more confusing. Participants in the economic projections included non-voting members. This suggested that non-voting members are having a more hawkish outlook than the voting ones. At the press conference, Fed Chairman Bernanke affirmed that the Fed's monetary stance would remain dependent on economic data.

Meanwhile, Bernanke said in a speech that the "highly accommodative monetary policy for the foreseeable future is what's needed in the U.S. economy," He said Fed is trying to communicate two different policy tools. And, Fed is "trying to achieve a substantial improvement in the outlook for the labor market in the context of price stability." He noted that there will be "sometime after we hit 6.5 percent before rates reach any significant level." He emphasized that "there is some prospective, gradual and possible change in the mix of instruments, but that shouldn't be confused with the overall thrust of policy which is highly accommodative."

On Friday, St Louis Fed Bullard, a known dove, warned that "pulling back on accommodation as inflation is sinking is not the right combination." He urged FOMC to "rethink its strategy" if inflation were to fall further. He noted, in that case, the "simplest thing" to do was to say "we'll stick to the QE program". On the other hand, Philadelphia Fed Plosser urged Fed to "begin to taper very soon" and he even wanted Fed to "end it by the end of this year".

Fitch noted in its Sovereign Review and Outlook that recent talk of Fed's tapering and the uncertain exit path of Fed will generate periodic bouts of market volatility. It noted that the emerging markets, including bonds, currencies and equities were hit disproportionately hard. While Fitch doesn't expect widespread credit distress, there will be concerns over slowing growth, China's financial stability, softer commodity prices and a series of political shocks in some EMs. Fitch doesn't expect a rate hike from Fed before mid-2015, but the prospect of tightening will increase risk facing weaker EMs.

In the eurozone, ECB president Draghi told the European Parliament in Brussels that the exit from the accommodative monetary stance is "distant". He reiterated the forward guidance that the governing council would keep rates at current or lower levels for an "extended period of time". He noted that the Central Bank will see "what the market reaction has been, is and will be to this statement." EU finance ministers agreed to release next tranche of bailout fund of EUR 3b for Greece.

S&P downgraded Italy's long term sovereign credit rating to BBB from BBB+, just two notches above junk level. The negative outlook suggested that there could be another downgrade this year or next. The rating agency noted "further worsening of Italy's economic prospects coming on top of a decade of real growth averaging minus 0.04 per cent." It lowered the GDP forecast in 2013 to -1.9%, down from prior projection of -1.4%.

Fitch downgraded France's credit rating by one notch to AA+, from AAA. It noted that budget risks "lie mainly to the downside, owing to the uncertain growth outlook and the ongoing euro zone crisis, even assuming no wavering in commitment to fiscal consolidation,"

The BOJ left the asset purchases program and the target rate unchanged in July, citing the country has shown signs of recovery. Note that it was the first time that the central bank used the word 'recovery' to describe Japan’s economic development since January 2011. The central bank raised its economic assessment and upgrade GDP and CPI forecasts for fiscal year 2013 at the meeting.
Inflation in China rose to +2.7% y/y in June, up from +2.1% a month ago. The reading on monthly basis stayed flat, indicating the improvement from a year ago was driven mainly by the price weakness last year. Food prices rose +4.9% y/y, up from a 3.2% increase in May while non-food price gained +1.6% y/y in June, same as May's reading. The low non-food inflation signaled that the output gap continued to grow. PPI slipped to -2.7% y/y in June from -2.9% a month ago. It fell -0.6% m/m in June. The China government announced in March its inflation target of +3.5% by year end. While it has also been lower than +4% for 2012, it can be missed given recent economic data showed weakness in the country's growth.

The IMF, in its latest World Economic Outlook presented a more pessimistic growth outlook. It forecast world economy would grow 3.1% this year, down -0.2% from previous estimate, and 3.8% (previous: 4.0%) in 2014. The lender forecast US GDP would reach 1.7% (previous: 1.9%) and 2.7% (previous: 2.9%) this year and in 2014 respectively. While emerging markets have remained the key growth engine, the IMF has also downgraded its estimates on China and Brazil. China's forecast was lowered to 7.8% (previous: 8.1%) in 2013. For 2014, it fell to 7.7% from April's projection of 8.3%. GDP growth in Brazil was lowered to 2.5% in 2013 from 3.0% in April and 3.2% for 2014 from a previous estimate of 4.0%. It noted that downside risks to global growth prospects "still dominate" and "the possibility of a longer growth slowdown in emerging market economies, especially given risks of lower potential growth, slowing credit and possibly tighter financial conditions if the anticipated unwinding of monetary policy stimulus in the U.S. leads to sustained capital flow reversals."