Dollar Suffers From Exhaustion

The mixed performance of the U.S. dollar today is a sign of exhaustion in the FX market. The currencies that have seen the greatest losses in recent weeks (AUD, NZD and CAD) are rebounding while the currencies whose losses were more limited (EUR, GBP and CHF) extended their slide. In other words, European currencies are under pressure while the commodity currencies are enjoying a relief rally. USD/JPY is unchanged for the fourth consecutive trading day, holding below the 50-day SMA at 99.40.

The GDP Effect
The shockingly large downward revision to first quarter GDP growth added further pressure on the greenback. The U.S. economy was initially estimated to have grown by 2.4% in the first three months of the year but due to a 0.8% overestimation of personal consumption, Q1 GDP growth was revised down to 1.8%. Personal consumption in particular grew only 2.6% compared to an initial estimate of 3.4%. While GDP numbers are very backwards looking, this revision is large enough to raise concerns that Bernanke is looking to reduce asset purchases prematurely. Given how he has looked beyond the increase in the unemployment rate in May, feel that the Fed will also downplay the reduction in GDP estimates and move forward with their plan to taper this year.

All of the action was in Asia and Europe where another 20bp decline in the overnight SHIBOR rate eased the tensions and uncertainty in Asia. Having hit a high of 13.44% last week, overnight lending rates in China have fallen from the stratosphere down to a more reasonable level of 5.55%. This decline eased concerns about holding AUD and NZD with demand further supported by the leadership change in Australia. The country's first female Prime Minister was ousted by Kevin Rudd, the man she replaced in a closed door Labor Party vote. Julia Gillard will now formally asks the country's governor general to make Mr. Rudd prime minister. While the markets have received Rudd's victory positively, the overall impact on the economy should be limited because the Labor Party is languishing significantly in the polls ahead of the September general elections. Treasurer and Deputy Prime Minister Wayne Swan has also stepped down and will be replaced with Transport Minister Anthony Albanese.

Euro Pressured
Meanwhile a report in the Financial Times that says Italy could face significant losses on the scale of billions of euros on derivative contracts they restructured during the sovereign debt crisis has put pressure on the euro. The single currency is also trading lower because ECB President Draghi's reminded everyone that the central bank stands ready to act if necessary. Having broken below the pivotal 1.3060-1.3065 support level, the EUR/USD is headed for 1.30 and could drop to its next support at 1.2940, the second standard deviation Bollinger Band.

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