Will Bernanke Undermine The USD?

This is an important week for the euro. For the past month, investors have been selling euros and buying dollars on the premise that the euro zone is in recession, U.S. is in recovery and the ECB is considering more stimulus at a time when the Fed is considering less. All of these assumptions will be tested this week with key event risks on both sides of the Atlantic. For the euro, the question is whether economic conditions continued to deteriorate in the March, boosting the odds of additional stimulus from the ECB. The latest euro-zone PMI numbers will be released this week along with the German IFO report. Economists are looking for a small recovery in manufacturing and service sector activity and if they are right, the euro could extend its gains. A few hours after the PMI numbers are released on Thursday ECB President Draghi will speak about the future of Europe in the global economy. If the data shows a deeper contraction in Europe and Draghi reminds investors that the central bank is watching economic data carefully to see if additional action is necessary, EUR/USD could extend its losses. While we believe that the euro could still experience further losses, this could be a week of recovery for the currency. Eventually Europe will start to reap the benefits of lower interest rates and a weaker currency, which is exactly the reason why Draghi may not say anything to threaten the current downtrend in the euro.

At the same time, in the dollar portion of this commentary, we outline some of the reasons why the greenback could experience a correction this week. Bernanke's testimony to the Joint Economic Committee and the FOMC minutes pose a double threat to the dollar rally. Even if the EUR/USD rebounds, it may turn out to be nothing more than a short-term recovery. We need to see a consistent improvement in the euro-zone economy and a broad based deterioration in U.S. data beyond manufacturing for investors to reconsider their expectations for ECB and Fed policy.

For the time being 1.28 is the most important near term support level for the EUR/USD. The currency pair rebounded off this level on Friday and extended its recovery today. EUR/USD also found support around this same area in late March / early April, making it even more significant but the rally should be capped at 1.30. If euro-zone data surprise to the downside and EUR/USD takes out 1.28, then the next major support for the pair will be at 1.2740.

How Bernanke Poses A Threat To The Dollar
Strap on your seatbelts because it is going to be another active and busy week in the foreign exchange market. U.S. economic data will take a back seat to Bernanke's testimony and the FOMC minutes on Wednesday. The relentless rally in the U.S. dollar over the past month indicates that investors are pricing in a major change in Fed policy and Bernanke's comments could either support or end the dollar rally. A number of Fed Presidents (mostly non voting members of the FOMC) have called on the Fed to scale back the amount of assets purchases as quickly as June. This is not the same as "tightening" monetary policy but in the eyes of investors, it's a step closer in that direction. If Bernanke drops even the smallest hint that they could vary bond buying -- either by talking about it directly or sounding more optimistic about the outlook for the U.S. economy, the dollar could hit new highs. However if he spends more time talking about the constraints in the U.S. economy and the fiscal drag, the dollar fall quickly and aggressively as speculators cut their long dollar positions after realizing that mapping a QE exit doesn't mean that the Fed is ready to head that way.

As one of the more dovish members of the FOMC, Bernanke will be very careful with his choice of words. After seeing how the markets have responded to the prospect of less QE, we don't expect Bernanke to openly say that the economy has improved enough to warrant changes in monetary policy. Managing an exit won't be easy and if anything, he will suggest that even if the Fed were to decrease asset purchases, they could increase them again if the economy weakens. In other words, while we don't expect Bernanke to kill the dollar's rally intentionally, his caution could lead to profit taking. The FOMC minutes also poses more downside than upside risk for the greenback because the meeting took place before the latest non-farm payrolls report. The number the Fed most likely had on hand was 88k. If you recall, payrolls for March were revised up from 88K to 138K and then increased to 165K in April but we did not learn this information until two days after the FOMC announcement. Therefore the tone at the last meeting could be more cautious with doves screaming a little louder, which would not be good for the U.S. dollar. In the long run, we still expect more gains in the greenback relative to other currencies but the FOMC minutes and Bernanke's testimony pose a double threat to the dollar rally this week.

AUD Recovery Hinges On RBA Minutes
The Australian and New Zealand dollars performed extremely well today as the currencies that experienced the deepest losses last week recovered the fastest. Whether gains in the AUD can be sustained will hinge largely on the minutes from the most recent Reserve Bank of Australia meeting, which are scheduled for release this evening. When the RBA last met, they surprised the market with a 25bp rate cut. Based on the deterioration in manufacturing, service and construction activity along with the drop in retail sales and smaller than expected increase in consumer prices, the RBA has every reason to ease at the time - and they did. The main motivation behind their rate cut was concerns about global growth and a strong currency. RBA Governor Glenn Stevens said that the exchange rate "has been little changed at a historically high level over the past 18 months, which is unusual given the decline in export prices and interest rates during that time. Moreover, the demand for credit remains, at this point, relatively subdued." They also admitted that, "employment has continued to grow but more slowly than the labour force, so that the rate of unemployment has increased a little, though it remains relatively low." As a result, the minutes should be dovish in which case the AUD/USD could resume its slide. However if the RBA suggests that one rate cut should be enough, the AUD/USD could experience a stronger short covering driven recovery. When it comes to the RBA, we can never underestimate their glass half full view of the economy. Meanwhile the best performing currency today was the New Zealand dollar which is up more than 1% thanks to better than expected service sector activity in April. Overall, New Zealand data hasn't been nearly as weak as other countries. Higher oil prices also spurred a recovery in the Canadian dollar but compared to the AUD and NZD, the gains were limited.

GBP: All Eyes On Inflation
Better than expected U.K. economic data continues to lend support to the pound, which traded higher against the euro and U.S. dollar. House prices rose 2.1% in the month of May, which drove the year over year gain in house prices to 2.5% from 0.4%. According to the property website, prices hit a record high this month driven in large part by demand for property in London. This is a great start for sterling this week as we have a tremendous amount of U.K. data on the calendar. Inflation reports are scheduled for release tomorrow with PPI growth expected to ease but CPI growth expected to accelerate. The Bank of England's primary focus is consumer prices and the expected easing of annualized CPI will help reduce concerns about runaway inflation. At its current pace of 2.8%, CPI is still running way above target but the central bank expects price pressures to continue to fall throughout the year. Aside from CPI, we also have retail sales, the minutes from the last BoE meeting and GDP on the calendar this week. Each and every one of these reports has the power to cause big swings in the GBP and collectively could drive a breakout move in the currency.

JPY: Hit By Finance Minister Comments
All of the Japanese Yen crosses traded higher today on the back of comments from Finance Minister Amari who said in an interview on Sunday that "it's being said that the correction of the strong yen is largely completed. If the yen keeps on weakening a lot more, it will have a negative impact on peoples' lives." This is the first time that we have heard a key policymaker criticize Yen weakness. While the Japanese are happy to see their currency decline in value, they have to balance its move and their goals with the pressure from trade partners. According to our colleague Boris Schlossberg, "It's difficult to say if Mr. Amari's comments were simply a political ploy to appease the international critics of Japanese ultra easy monetary policy or whether they were made out of genuine concern for the fact that the weaker yen is driving up energy costs in the Land of the Rising Sun. We doubt that Japanese officials are satisfied with the current exchange rate level and may have simply wanted to slow the rate of ascent of USD/JPY in order for the Japanese economy to absorb the recent price changes."

Kathy Lien, Managing Director of FX Strategy for BK Asset Management.