Firm Start To FX Trading

Currencies and equities are starting the busy week on firmer footing with the U.S. dollar holding steady or trading lower against all of the major currencies except for the Japanese Yen. The weakness of the Yen confirms that risk appetite improved over the weekend as investors turn their focus to Wednesday’s FOMC meeting and Chinese manufacturing PMI report along with Thursday’s euro-zone PMI numbers.

Fundamentals Look Good
While most of the speculation about what the Federal Reserve will say or do centers on the potential for a lower GDP and inflation forecast for 2013, investors don’t seem to be fazed by this possibility because U.S. equity futures are trading sharply higher. Once a quarter the Fed updates its GDP, PCE price inflation and employment expectations and this month, most of the leading banks on Wall Street are calling for downgrades because current GDP and inflation trends are weaker than what the Fed anticipated back in March. Yet we continue to see gradual improvements in the U.S. economy. For example, according to the Empire State survey, which rose from -1.43 in May to a three-month high of 7.8 in June, manufacturing conditions in the NY region recovered after pulling back last month. This may only be one piece of early U.S. data but it provides hope for the U.S. economic outlook.

The main question this week, however, is what Bernanke will say about tapering asset purchases and what kind of impact it will have on deleveraging in the FX and fixed income markets. The past few weeks have been brutal for both markets and considering that a large part of the deleveraging was caused by the reset of monetary policy expectations for the Federal Reserve and the Bank of Japan the key to stabilization this week lies in the hands of the U.S. central bank. While we still feel that the Fed wants to taper asset purchases this year, Bernanke will go out of his way to distinguish the difference between tapering and tightening. He will try to reassure investors that cheap and easy money is not going away anytime soon. If he is successful, that should mean more weakness for the U.S. dollar and recovery in high beta currencies. However if Bernanke overemphasizes the central bank’s plans for tapering, the dollar could resume its rise, leading to a surge in Treasury yields – an outcome that the Fed Chairman may not want to see. Speculation about these possibilities will continue to grow and affect FX trading into Wednesday’s FOMC announcement.