Bernanke's Policy Bias To Drive USD

Currencies and equities traded higher Tuesday ahead of Federal Reserve Chairman Ben Bernanke's testimony before the Joint Economic Committee. While the FOMC minutes will be released the same day, we believe his monetary policy bias will be the main driver of dollar flows. Bernanke's views will give us a good sense of whether the market's expectations for tapering QE are overblown. Based on the relentless rally in the U.S. dollar over the past month, investors are pricing in a major change in Fed policy and Bernanke's comments could either support or end the dollar rally. Based on the latest comments from FOMC voters Dudley and Bullard there's no clear support for tapering asset purchases. Dudley and Bullard are on two opposite sides of the dove hawk scale and yet Dudley says that he's not sure if the next move in QE will be up or down while Bullard says he doesn't see a good case for tapering unless inflation rises. So the ball is now in Bernanke's court. If the Fed Chairman drops even the smallest hint that he supports reducing 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 repeats that bonds could be increased OR decreased and spends more time talking about the constraints in the U.S. economy or the fiscal drag, the dollar could 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 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. He certainly doesn't want to say anything to drive bonds yields even higher. 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 nonfarm 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 Wednesday. Aside from the FOMC minutes and Bernanke's testimony, existing home sales are also scheduled for release.

GBP: Time For BoE Minutes And Retail Sales
The worst performing currency Tuesday against the euro and U.S. dollar was the British pound. Sterling tanked after softer inflation reports. Both consumer and producer prices surprised to the downside with PPI input and output declining in the month of April and consumer price growth slowing to 0.2% from 0.3%. This cut the year over year rise down to 2.4%, the lowest level of inflation since October 2012. The equally large decline in core prices confirmed that the decline in inflation is genuine and for the Bank of England this puts additional easing back on the table as so far it seems that CPI may undershoot the BoE's expectations. However the real key to additional stimulus lies in the performance of the economy and Wednesday's U.K. retail sales report will provide us with a better look at how it is doing. Retail sales are expected to turn positive after falling 0.7% the previous month. Spending has been extremely volatile and based on the drop in consumer prices along with a decline in spending reported by the British Retail Consortium, we could see another month of weaker demand. The Bank of England minutes will be released at the same time as retail sales and will be just as important. Considering that the BoE met after a series of better than expected PMI numbers, we expect a tone of optimism.

EUR: Consolidating Above 1.28
For the fifth consecutive trading day, the euro remained stuck in a range trading between 1.28 and 1.2950. The lack of market moving euro-zone data in the front of the week restricted movements in the currency. This morning's German producer price report showed inflationary pressures continuing to fall in the euro zone's largest economy. The 0.2% decline brought annualized PPI growth down to 0.1% from 0.4% the previous month. Lower price pressures will most likely keep the ECB dovish but the key to additional easing is not inflation but economic performance. Euro zone current account numbers are due for release Wednesday and with German and French balances increasing in March, the euro-zone figures should show improvement as well. EU Leaders will be holding a summit in Brussels on Wednesday so watch for headlines related to economy. While the EUR/USD has consolidated above 1.28, Wednesday's key Fed events could drive it out of this range with volatility continuing into Thursday and Friday on the back of euro zone PMI numbers, a speech from ECB President Draghi and the German IFO report. In other words, don't get too comfortable with the recent range bound trading in the euro as a breakout could be right around the corner.

AUD: Main Takeaway From RBA Minutes
After a one-day respite, the New Zealand and Canadian dollars resumed their slide against the greenback while the Australian dollar steadied. A decline in Australian leading indicators and benign RBA minutes prevented the AUD from enjoying a stronger recovery. The minutes did not provide much in the way of guidance on future monetary policy but the central bank's careful choice of words, when they said the "inflation outlook would afford scope to ease further" and they decided to use "some of that scope" to ease still suggests that there is room for more stimulus. The main takeaway from the minutes is that the strength of the Australian dollar in April was the primary motivation in their decision to cut interest rates. Aside from constricting export activity, the rise in the currency also reduces inflationary pressures, giving the central bank the flexibility they needed to ease monetary policy. Since then, the AUD/USD has fallen aggressively, losing approximately 800 pips from its April high making the currency far less of a concern these days. Therefore another rate cut by the RBA would probably require material deterioration in economic data. Meanwhile the NZD/USD shrugged off stronger credit card spending numbers. Australian consumer confidence is scheduled for release this evening followed by Canadian retail sales.

JPY: What Amari's Conflicting Views Say About Yen Sentiment
Once again, the Finance Minister of Japan has caused unnecessary volatility in the Japanese Yen. The Yen recovered all of Monday's losses after Finance Minister Amari retracted Sunday's comment that "the correction of the strong yen is largely completed." Now Amari is saying he can't say when the correction from a strong yen will end. While it is clear that Amari has some reservations about the Yen move, we suspect that he was pressured by his colleagues in other parts of the government to backpedal on his comments because a) they don't share his views and b) they want avoid a deeper correction in the Yen that would reverse their recent efforts. Last night's economic reports were disappointing with super market sales turning negative last month on a year over year basis and the country's all industry activity index dropping 0.3% in March after rising 0.6% in February. Japanese trade numbers are scheduled for release this evening and unlike previous months, the country's trade deficit is expected to widen as imports rise alongside exports. While the weak Yen and Abenomics helps to support the economy, Japan has been a big importer of energy after the 2011 earthquake and tsunami. The Bank of Japan is also expected to deliver their monetary policy decision this evening -- no changes in policy are expected.

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