Dollar Reversal Risk High, If Fear Doesn’t Fill In For QE3 Debate

The extended holiday weekend for the US and UK sapped the speculative drive from the global markets Monday. However, this lull will soon pass, and we will return to the menacing volatility and equity drop seen the second half of last week. Is the market destined to have its faith in persistent capital gains and central bank stimulus shaken, or has the extended weekend cured investors of those doubts? Taking the temperature of sentiment ahead of the official US open is difficult as the FX market carved out an exceptionally small range through the opening session. The Dow Jones FXCM Dollar Index (USDollar) posted its smallest daily trading range in a month – a mere 28 points – while the equally risk-sensitive yen crosses failed to take up the cause of risk trends. That said, a strong performance for Euro-area stocks could frame expectations in the absence of commitment Tuesday morning before the New York session begins.

When projecting either activity levels or underlying direction, the best instigation for conviction is a meaningful fundamental catalyst. Last week, risk appetite was shaken by the admission by Federal Reserve Chairman Ben Bernanke and suggestion from the May FOMC minutes that a ‘tapering’ of the $85 billion per month QE3 stimulus effort could be implemented over the next two or three central bank meetings. Speculators have been raising their suspicions of this threat / opportunity for a number of weeks – and this significant first step towards reversing the US and global market’s important backstop was no doubt a significant contributor to the dollar’s impressive rally this month. However, having had time to assess the situation without panicked volatility overwhelming traders’ senses; fear of the eventual Fed exit may not easily take root.

Though there was evidence to suggest both Bernanke and the Committee saw the possibility of a moderation in Fed stimulus over the coming months, there was also clear evidence that this would unlikely be a consensus for the June 19 policy gathering. That presents a problem as speculation of the tapering has played a significant part in the dollar’s charge higher – particularly when risk trends have held steady. Without a productive slump in stalwart capital markets, the greenback may find itself out of anti-stimulus fodder to justify multi-year highs. Once again, FX traders will direct their attention to risk trends; and regardless of direction sentiment takes, we are likely to see an active market this week.

Japanese Yen: Volatility in Japan Adds to Dangers for Yen Bears
Nowhere was the break in last week’s volatility fever more appreciated than in the Japanese financial markets. While the Nikkei 225 extended its decline Monday, the momentum and erratic intraday swings were notably tamed. Elsewhere, the yen crosses and JGB (Japanese Government Bond) yields were little changed through the opening session. That being said, conditions are far from stable. To start the week off, there was concern raised in both a speech by Bank of Japan Governor Kuroda and the minutes from the last central bank meeting. Kuroda remarked that excessive risk taking could destabilize the financial system – yet in a brush of disregard said he saw no issues despite JGB volatility or equities’ surge. Meanwhile, the minutes show doubt amongst some members that the 2 percent inflation target will be achievable.

Euro Traders Should be Ready for Updates on Spain, France, Portugal, etc.
The euro posted a modest advance against most counterparts through Monday’s session, helped by a news report that suggested that Germany was making a behind-the-scenes change on its strict austerity stand for the Eurozone. According to a weekly news magazine Die Spiegel, Chancellor Merkel and Finance Minister Schaeuble were planning to change the region’s perception of their influence over the region by supporting growth through possible support programs for the periphery. This would represent a remarkable – and likely costly – change for Germany, so skepticism will be maintained in heavy doses; so don’t expect a full-blown speculative rally on this gossip alone. The upcoming event risk is far more tangible. Spain will release its budget balance through April. The Bank of Portugal is due to release its Financial Stability Report. And, the ECB’s Noyer is expected to deliver his annual letter on France’s health – timely given an S&P ratings warning Monday.

Australian Dollar Oversold so Long as Fundamentals Don’t Kick In
Interest rates – and interest rate expectations – have lost their sway over the Australian dollar. The Reserve Bank of Australia (RBA) has maintained a steady yet infrequent regime of policy easing for months. While the most recent cut was something of a surprise, yields on the traditional carry trades has long been stagnant and the market’s appetite for yield at any cost unflappable. So where is the recent bout of individual Aussie weakness coming from? Reserve diversification? Possibly, but that is unlikely to hold alone. Now if risk aversion kicks in…

Swiss Franc: Tempered Euro Influence Makes for Data Sensitivity
The correlation between Euro-based and Swiss franc-based pairs has cooled notably. In fact, the 20-day (1 trading month) relationship between CHFGBP and EURGBP has dropped to its lowest level since September 2011 – just before the SNB floor was put into place. This tells us that the franc isn’t simply tracking the euro around. As such, data like the upcoming trade reportcan generate more volatility for the franc.

Canadian Dollar at Crucial Levels before BoC Rate Decision
Monetary policy decisions are carry more influence over the market nowadays – expectations heading into the events as much as the policy decisions themselves. Canada is particularly interesting as the BoC has refused to relinquish its warning that a hike would be the next move despite cooling growth trends and temperate inflation. Will the market price something dramatic from Governor Carney on Wednesday?