As Tensions Ease, Will Dollar Do Same?

Currencies and equities ended Tuesday higher as the risk of a strike on Syria continues to recede. Two stories dominated the discussion in the financial markets on Tuesday -- Apple's new product launches (which was arguably disappointing) and Syria. The U.S. Senate has postponed its vote on Syria and President Obama was preparing to address the nation with the hope of shoring support for action. Even so it seems that the President is softening his tone and growing more amenable to the idea of a diplomatic solution. However a strike is not completely off the table because there's some resistance to Russia's push to preclude the threat of force in any UN Resolution. Currency traders should watch these ongoing developments carefully as the next 24 to 48 hours of trade will hinge on these developments. If the U.S. accepts Russia's proposal for Syria to turn over its chemical weapons program to international review, control and destruction, we could see further gains in high beta currencies and a loss of a safe haven bid for the dollar. There are still no U.S. economic reports scheduled for release on Wednesday, which means geopolitical risks should dominate currency flows.

Selling dollars broadly however may not be the best idea because as we have seen in Tuesday's price action, USD/JPY and USD/CHF have also benefitted from improved risk appetite while the EUR/USD and GBP/USD have not been able to join in on the action. This suggests that forex trades need to be extremely selective with trading the U.S. dollar. The greenback has fallen sharply against the comm dollars (AUD, NZD and CAD) and could continue to decline, particularly against currencies whose growth outlook had once been underwhelming but is now improving. We also feel that some of the most attractive opportunities to sell the dollar will be against deeply oversold emerging market currencies. Last month, the plunge in currencies such as the Indian Rupee, Indonesian Rupiah, Turkish Lira and Brazilian Real made headlines around the world but little has been said about their recent recovery. The Rupee is leading the gains, rising 7% against the dollar since the beginning of the month, the Brazilian real is up nearly 5% and the Indonesian Rupiah and Turkish Lira are up more than 2.5%. If tensions around Syria continue to ease, we could see a further decline in the dollar and a more significant recovery in these emerging market currencies. G10 currencies should also benefit from dollar weakness but as we have seen, the sell-off could be limited.

EUR: Italian Bond Yields Surpass Spanish Yields
Compared to other major currencies, the gains in the euro Tuesday were modest and the reason why EUR/USD was unable to join the recovery is because of ongoing concerns about the outlook for the euro-zone economy. French industrial production plunged in the month of July and this decline is consistent with weaker manufacturing conditions in Germany. These reports highlight the vulnerability of the region's recovery, making the currency less attractive at a time when Italian politics also pose a new threat to its stability. The Senate Subcommittee in Italy convened for a second day to discuss the possibility of stripping former Prime Minister Silvio Berlusconi of his Senate seat. The bond market in Italy is extremely nervous and this anxiety has spilled over to currencies. For the first time in 18 months, Italian 10-year bond yields rose above Spanish bond yields of the same tenure, which suggests investors now view investing in Italy riskier than Spain. This move can be attributed entirely to the political risk in Italy. While EUR/USD is holding steady because of U.S. dollar weakness, there could be additional downside opportunity in euro crosses such as EUR/GBP, EUR/AUD and EUR/NZD. Italy is the third largest economy in the euro zone and if a tiny country like Cyprus can threaten the region's stability, then Italy is a much bigger headache for the region. Berlusconi has threatened to withdraw his party's support for the current government if he is pushed out of the Senate and unfortunately his People of Freedom Party is a critical link in Prime Minister Enrico Letta's coalition government. An expulsion could collapse the less than one-year old government, force them into snap elections and destabilize the economy. Political uncertainty is never good for a country and in the case of Italy a fresh political crisis could drive Italian bond yields sharply higher and the euro lower. Under Italian law, a public official cannot serve in the government if he or she has been convicted a crime carrying a sentence of two years or more. Berlusconi was sentenced to a four-year prison term on tax fraud that has been reduced to a single year because of prison overcrowding and he is given the choice to serve the time in jail, under house arrest or through community service. The former Prime Minister doesn't want to serve any sentence at all and because losing his status as a government official would mean that he would also lose certain legal protections. The Italian Senate is faced with a very tough choice that could pose a major risk to the fragile recovery in the euro zone.

GBP Climbs to 2.5-Yr. High Ahead Of Employment Report
The British pound rose to a 2.5-month high against the U.S. dollar ahead of the U.K. employment report. If the number of people claiming unemployment benefits declined more than expected in the month of August, it could be just the push that GBP/USD needs to break above 1.5750 and climb to its highest level in over six months. The faster expansion in the service, manufacturing and construction sectors should have led to a further improvement in the labor market and if we are right, sterling could rise to new highs. However if job losses intensified despite increased economic activity, the currency could come crashing down as investors buy into the central bank's concerns about an unsustainable recovery. We believe that U.K. data will continue to surprise to the upside, confirming that the recovery is on track. According to last night's RICS house price balance report, house prices rose at its fastest pace in nearly seven years with sales volumes hitting multi-year high. This report confirms that the government's programs such as the Funding for Lending Scheme is finally paying off.

NZD: What To Expect From The RBNZ
As the Chinese economy continues to stabilize, the commodity currencies have been big beneficiaries. The Australian, New Zealand and Canadian dollars extended their gains on the hope that stronger Chinese growth will lead to healthier demand for global exports. Industrial production in China grew a whopping 10.4% in the month of August, retail sales increased 13.4% and fixed income investment rose 20.3%. All three of these releases beat expectations and confirm that China's recovery is gaining momentum after a sluggish first half of the year. These improvements have also made Australian business a bit more confident according to NAB, whose business confidence index surged to its highest level in more than two years last month. Part of the optimism was also linked to this weekend's elections and the hope that a new government would do a better job of reinvigorating the economy. It will be interesting to see if consumer confidence, which was scheduled for release Tuesday evening, also improved. The most exciting event risk over the next 24 hours will be the Reserve Bank of New Zealand's rate decision. The RBNZ is not expected to change interest rates but a strengthening local economy, an improving outlook for Australia and China and lending restrictions that could cool the housing market could prompt optimism from the central bank. The only area of concern is the level of the currency and whether the central bank still considers it overvalued against the AUD.

USD/JPY Back Above 100 Driving All Yen Crosses
USD/JPY rose to its highest level in six weeks and this strength helped to drive all of the Japanese Yen crosses higher. The breakout move in USD/JPY was fueled by the possibility of a diplomatic solution to the Syrian conflict and not surprises in U.S. or Japanese data. In fact, last week's softer than expected U.S. labor market report should have encouraged additional profit taking on long dollar positions. However, with the threat of a military strike on Syria diminishing, risk appetite has improved and all of the Yen crosses including USD/JPY benefitted. Meanwhile the August Bank of Japan minutes contained very little surprises. The BoJ continued to express confidence in their monetary policy actions and its long-term impact on the economy. They called on the government to press forward with fiscal reforms and help keep bond yields under control. While the Yen received a lift after the last BoJ meeting where the central bank promised to provide additional stimulus if the consumption tax threatens the recovery, these minutes are from the August and not the September meeting which explains why they did not provide additional clarity. Instead Yen traders will need to look to BoJ board member Ishida's Tuesday-night speech for better insight on the central bank's monetary policy plans.

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