Dollar Extended Rally After Italian Election

The Dollar continued to be the strongest major currency last week while the Euro was the center of focus. Inconclusive elections in Italy left the country with a hung parliament, and possibly much political uncertainty. Solid bond auctions in Italy gave the common currency some interim support, but it finally gave up again with EUR/USD breaching key psychological level of 1.3 briefly. The Euro situation reminded us how vulnerable confidence is in the eurozone, despite efforts by ECB and political leaders. We could look at the EUR/CHF pair, which was back below 1.21 at the start of 2013, shot up to as high as 1.2568 and hammered back to low as 1.2118 within just two months. While the US was troubled by sequestration, the dollar was not much affected, based on its save haven status. Dollar index surged through 82 to close at 82.28, while US stocks managed to reverse earlier lost and closed with a strong note.

The NZD/USD and USD/CHF pairs were the biggest movers last week, dropping -1.5% and rising 1.47% respectively. Our strategy of long USD/CAD, short GBP/USD was correct even though the two pairs were the biggest movers. Technically, a key development is EUR/USD's breach of 1.3 psychological level which now raised the chance that rise from July's 1.2042 has finished at 1.3710 in late January. We'd like to note another development from last week, the break of 0.9388 in USD/CHF, which suggested that the corresponding decline from July's high of 0.9971 has completed at 0.9021 in early February. The move in USD/CHF could be seen as a strong warning for EUR/USD. The euro also looked weak: crosses with EUR/GBP topped while the EUR/AUD's correction extended. Indeed, the euro will possibly under-perform the sterling in near term, even though the pattern in GBP/USD was definitely more bearish than the EUR/USD.

The yen's corrective trading continued and while yen crosses found temporary bottom, we believe that they were just starting another leg in the consolidation patterns. We prefer not to go long in yen crosses yet. While a break of 94.55 in USD/JPY is possible, the selloff in yen might not be as one-sided as in January and February. Hence, we'd prefer to avoid yen pairs. AUD/USD's downside momentum remained unconvincing even though the choppy fall from 1.0597 extended. USD/CAD's rally did continue but it's looking tired, and it should be time to take profit and wait for a near term pull back.

So overall, we'd prefer to continue to short GBP/USD and start shorting Euro on recovery.

To recap some of last week's events: in the US, the Senate rejected a pair of partisan proposals to replace the spending cuts and no congressional action is planned before those cuts take effects. And as usual, the politicians traded blames on each other for the impasse. The Congressional Budget Office expected that this would reduce US growth this year by as much as 0.6%. In the testimony before the Senate Committee, Fed Chairman Bernanke discussed benefits and costs of the central bank's asset purchases. His overall tone remained rather dovish and he down played the costs of the program. Despite debates over whether the Fed should taper asset purchases, the testimony showed no indication that the Fed would slow or stop monetary easing. Meanwhile, Bernanke's comments on the economic outlook were similar to those made in his press conference following the December FOMC meeting.

In the eurozone, focus was on the inconclusive election in Italy. Bersani's party won majority in the lower house but failed to do so in the upper house. Italian yields were sent to a three month high on political uncertainties. Bersani said he would not form a coalition with Berlusconi but he is prepared to compromise with Grillo's party. Berlusconi called for new elections instead. So far, markets are still unclear on what will happen next in Italy. ECB president Draghi said that the eurozone economy is still weak, but he's optimistic that the accommodative monetary policy would help drive a "gradual recovery" in 2013. He also expect that the central bank would not removal policy stimulus any time soon as inflation would "significantly" undershoot its 2% target in 2014. Meanwhile, he noted that the "benefits of the painful actions" of austerity have not yet materialized and the "economic adjustment is coming at a heavy social cost". He emphasized that austerity is for doing "their own benefits" and urged that reforms must continue. This was somewhat an indirect response to the inconclusive elections in Italy.

In Japan, prime minister Abe formally nominated Asian Development Bank president Kuroda as the next BoJ governor to succeed Shirakawa. Iwata, a professor, and Nakaso, a BoJ executive director, were nominated as deputy governors. Yen weakened mildly towers the end of the week on expectation that the team of Kuroda will pursue aggressive easing when they come on board. And there would be eye-catching measures like buying risk assets or bonds on a large scale. But it should be noted that yen should have exhausted selling in near term and we'd expect more consolidation ahead in March, and probably before Kuroda's first BoJ meeting in April.

Sterling extended recent decline on Moody's downgrade as well as weak economic data. The PMI manufacturing index dropped sharply to 47.9 in February, down from 50.8. The contractionary reading was a shock to economists as it's generally expected a mild expansionary reading at 51. It raised concerns that the UK cannot avoid the so-called triple dip recession.

In China, the official manufacturing PMI dropped to 50.1 in February versus expectation of a rise to 50.5. The HSBC manufacturing PMI also finalized to 50.4, much lower than prior month's 52.3.