Dollar Suffers Biggest Drop In Two Months: Is This A Reversal?

The dollar dove this past session – leading FX traders to wonder whether this was just a sharp response to big moves from EURUSD, GBPUSD and AUDUSD or the establishment of a bigger trend. That assessment should be made on the merits of the fundamental drive be behind this tentative swell in volatility as well as the themes that are likely to control the herd moving forward. First, an assessment of performance. The Dow Jones FXCM Dollar (USdollar) drop measured 0.5 percent for the biggest decline since January 10. The pace of the decline isn’t as important to the story as where this decline has occurred. With Thursday’s stumble, the USDollar Index has dropped back below 10,500 and in doing so has finally broken from a consistent rising trend channel that has focused bulls since late January. And, for the technically inclined, this has all happened after the currency failed to overtake the midpoint of the past decade’s range.

From a fundamental perspective, the situation is less clear-cut than the technicals would suggest. Through recent history, we look for two particular fundamental themes to offer meaningful support for the greenback: risk trends and an improvement in the fiscal outlook or the US government. In Washington, conversations between the White House, House Republicans and Senate Democrats are ongoing; but we haven’t seen serous progress. Alternatively, we can look to risk trends for an explanation. The Dow Jones Industrial Average (US30) has rallied for 10 consecutive days – the longest consecutive period of gains since November 1996. We haven’t had an 11-day move since January 1987. However, measuring risk trends through the stimulus-fluffed equity markets isn’t particularly reliable considering the dollar and Dow have run the same course for a number of months.

Yet, where US equities advance isn’t a solid means of support for a sustained dollar decline; the reverse could very well tighten up the recently ignored fundamental correlation. Low volume and extreme consistency in stocks’ drive to a record high speak to winded conditions that could encourage profit taking and deleveraging. It isn’t difficult to tip a state of ‘panic’ in these conditions, and investors don’t think twice when bidding the dollar during such conditions. Meanwhile, keeping an eye on the health of the banking system 14 of the 18 banks the Fed stress tested had their capital plans (dividends, share buybacks) approved without conditions. Unloading a cash reserve at these heights is very risky…

Euro Officials Tread Bullish Line as Effort Shifting Towards Growth
The financial and economic outlook for the Eurozone took a divergent path this past session. Keeping track of the leading edge of a possible crisis revival, the story that Troika representatives left Greece without an agreement for the next (€2.8 billion) aid disbursement has generated some concern over the perpetually needy and economically devastated county’s health. Elsewhere, Spain’s surprise, ultra-long dated bond auction seemed to draw relatively weak demand and the Bank of Italy suggested national banks in the red should not pay dividends (no better way to see a capital flight). However, that may all be trumped by signs that the EU is making a shift from cracking the whip on austerity to supporting stimulus and jobs. If that is the case, this would build on a bullish euro case with the ECB still seeing its balance sheet contract.

British Pound: BoE Governor Mervyn King Says Pound at Fair ValueWhile there are concerns about the balance between budget restraint and frequented recession in the United Kingdom; for FX traders, the more immediate concern has been the threat that the Bank of England (BoE) is preparing to expand its stimulus effort materially sometime over the next three to six months. That is something of a distant concern, however, and the more than 1300-pip drop from the cable (GBPUSD) so far this year seems to be somewhat excessive. Well, that realization may have dawned on traders this past session as the pair posted its biggest daily rally (nearly 1.6 percent) since July 1, 2010. Yet, be cautious on expectations of consistency if risk trends start to falter.

New Zealand Dollar Restrained Despite RBNZ 10-15% Overvalued Comment
We have seen ineffectual monetary policy threats and efforts in the past (Japan could write volumes on the topic), but it is still surprising to see exchange rates ignore increasingly blatant warnings. For the New Zealand dollar, the Reserve Bank of New Zealand’s warning that all rate hikes were off was supplemented by Governor Wheeler’s remark in Testimony that the currency is around 10 to 15 percent overvalued against its primary counterpart. The US currency’s own trouble this past session certainly complicates that reaction. Furthermore, bond auctions like the one we have seen this morning (demand between 6 to 7 times the offer) speaks to investment capital flows remaining in place.

Australian Dollar: RBA Rate Outlook Most Optimistic in 19 Months After Data
Given the exceptional amount of easing the Reserve Bank of Australia has done over the past few years, policymakers are no doubt looking for evidence that it is time to put a cap in rate cuts – as are FX traders. While it may not be the decisive indicator, the blowout employment report from yesterday certainly tips a scale that was already moving back towards balance. How has this impacted speculators? We see in overnight swaps less than a 50 percent chance of another rate cut from the RBA over the next year – the most hawkish read since July 2011.

Japanese Yen Moves Beyond a Serious Barrier to Further Declines
This morning, Japan’s Upper House of Parliament confirmed Haruhiko Kuroda as Governor of the Bank of Japan while Hiroshi Nakaso and Kikuo Iwata were given the nod for the Deputy Governor positions. Their approval was expected, but it nevertheless removes a serious buffer to enacting the stimulus offensive that the nominees described in such color. We have days before a risk view will be buffered in the power shift.