Dollar Rallies After Fed Talks QE3 Exit, Will EUR/USD Break 1.2800?

The markets have sought out guidance on the future of the Federal Reserve’s QE3 plans to shape their speculation, and that is exactly what Fed Chairman Ben Bernanke and the FOMC minutes offered. Tentative but tangible commentary about the eventual reduction in the current $85 billion-per-month program spurred the traditional ‘risk aversion’ move from the capital markets. For the S&P 500, an intraday reversal tore the index from fresh record highs to a dangerous shift in momentum that threatens a deeper rollover. Leading the safe havens – and a direct victim of the supply-and-demand elements of the US money supply – the Dow Jones FXCM Dollar (USDollar) surged above 10,850 to its highest level since July 2010. These are both meaningful developments, but they don’t exactly confirm conviction just yet. Just like a technical breakout does not necessarily guarantee a lasting trend, a fundamental volatility swell does not ensure a systemic shift in capital.

To determine whether the market will finally pitch into a fear-driven deleveraging and risk aversion spiral, we need to see the proper fundamental catalyst to unite investors’ fears about their exposure. The Fed’s commentary does a little more than sow the seeds of doubt. The action began in the New York morning session when central bank head Bernanke testified before Congress’ Joint Economic Committee. Much of what he offered were words of caution. He clearly warned that premature tightening could undermine the US economy’s recovery. Yet, tightening and tempering are two different concepts. For speculators that have accessed record levels of leverage through the NYSE and have driven carry-favored yen crosses far off track of their yield differentials, what really stuck out was his suggestion that “in the next few meetings…(they) could take a step down in (their) pace of purchases.” How much in the way of capital gains can investors hope to squeeze out in just a few more months – because interest / yields / dividends aren’t up to par.

The hand wringing intensified a few hours later when the transcript of the Federal Open Market Committee’s (FOMC) last meeting was released. While the group noted that ‘many’ members thought that further progress was necessary to slow the policy cadence, shift away from certainty was unmistakable. Furthermore, ‘some’ on the Committee believed QE3 could be slowed as early as the June meeting. In the end, it is not confidence of growth, but fear of disastrous side effects (a market bubble) that would ultimately encourage the shift – and such fears were also noted. This is far from confirmation of a change in bearing for the world’s most prolific stimulator, but it offers a clear reason for doubt. And, at record price and exposure (leverage) levels, that may be enough to start the contagion.

Japanese Yen Traders See the Limits, Ill Side Effects of BoJ Stimulus
As expected, the Bank of Japan decided to keep its monetary policy bearing unchanged from the already remarkable objective of increasing the country’s money base by ¥60-70 trillion yen a year. This serious policy move was made little over a month ago, so a period of ‘wait and measure’ is to be expected. Yet, that may be little comfort for FX traders who have driving the yen down between approximately 25 percent in the span of six months – an extreme move for the liquid currency market. While pairs like AUDJPY, EURJPY and USDJPY probe multi-year highs, the carry (yield differential) that they offer are at historical lows. Capital gains through expectations of a constant bid are the only hope of real return. Meanwhile, the BoJ is facing a serious problem. With an aim to end deflation, interest rates will inevitable rise in Japan. However, the 10-year JGB yield surged a fourth day by 4 percent. It is now double its low in April. This is dangerous for a country with so much debt…

British Pound: A Round of Data and Nothing Went the Sterling’s Way
There was plenty of fundamental fodder on the UK docket this past session, and none of it was good for the sterling. Retail sales figures dropped the most in two years (1.4 percent) while the CBI manufacturing activity trends report posted a deeper contraction than expected. What is really troublesome in these times of stimulus, the disappointing figures are unlikely to encourage more BoE support. The BoE minutes showed the same 3 MPC members were outvoted to keep policy unchanged. Coming up, watch the second read of UK 1Q GDP to see critical details.

Euro Optimism to be Tested by Recession Warning in PMI Data
As blatant as the updates on monetary policy for the UK, Japan and UK were this past session; there seems a lack of appreciation for the subtlety of Europe’s policy regime (if few people are speculating on a change, such a move will have greater impact down the line). Worth noting though, ECB member Praet remarked on the group’s exploration of SME (small and medium-size business) loans and quality reviews of asset backed securities. In the upcoming session, we will be reminded of Europe’s biggest problem – recession – with the monthly PMI figures.

Australian Dollar Slides Further on Stimulus Concerns, Chinese Data
If there is a fear of risk, the Australian dollar will certainly take a brunt of the hit. This currency was already suffering while other benchmarks for sentiment – like equities – were still holding steady. A new addition to the currency’s troubles was added this morning when the HSBC Chinese Manufacturing PMI report for May reported a dip back into contractionary territory (49.6). A near-term rebound only works in a risk stable market.

Canadian Dollar Breaks from Multi-Year Range with Help of Retail Stats
Since October 2009, USD/CAD has been guided lower by a consistent descending trendline. This past session, the pair finally closed above the high-profile technical level. The unique strength of the US dollar and general risk aversion support the break above 1.0300; and if sentiment really starts moving, that will be the catalyst for a trend. Meanwhile, the Canadian retail sales miss may hint at trouble in economic paradise.