Guess What Next Week's Dollar Hinges On?

The month of June has proven to be an extremely volatile period in the forex market as the U.S. dollar fell aggressively against many major currencies. Unfortunately we can't expect the markets to calm anytime soon with a heavy dose of economic data expected from countries around the world. The U.K. and Australia will release monetary policy minutes, the Swiss National Bank will hold a monetary policy meeting and of course -- we also have the Federal Reserve's monetary policy announcement on the calendar. In addition to these event risks, Eurozone PMIs, New Zealand GDP, UK retail sales, US manufacturing data and Canadian retail sales are also scheduled for release. Yet there's no question that of all these events, the most important will be the Fed meeting. Much of the volatility in the financial markets has been caused by the uncertainty of Fed policy. There's been a lot of talk about tapering asset purchases, which has caused stocks to weaken but at the same time, central bank officials and noted Fed watchers have stressed that a reduction in Quantitative Easing does not equate to tightening. They are absolutely right and we think that the rest of the market is beginning to realize this connection as well but based on the reaction to Jon Hilsenrath's article this week, there are still a subset who need convincing.

The outlook for the dollar this week will largely hinge on what Bernanke says at his post monetary policy meeting press conference. The central bank is not expected to alter its Quantitative Easing program but they will release their latest economic projections and provide clarity on their future intentions. We will be talking about the Fed all next week but in a nutshell with U.S. bond yields on the rise, we expect Bernanke to stress the different conditions needed for tapering vs. a rate hike. He will remind everyone that even if they decide to taper in a few months (a benchmark many Fed Presidents have used), they are still a long way from tightening monetary policy and the outlook for the greenback will depend how much this point is stressed. As for their forecasts, there's a mild chance that the Fed could downgrade its GDP estimates.

Based on the latest U.S. economic reports, the Federal Reserve should remain cautiously optimistic. Industrial production stagnated in the month of May after falling 0.4% in April, a sign that the momentum is fading in this part of the economy. Consumer confidence dropped to 82.7 from 84.5 in June according to the University of Michigan Consumer Confidence index. After rising to its highest level since July 2007, a pullback is natural. Americans have grown less optimistic about current economic conditions but their hope for the future brightened with the expectations component of the report rising to its highest level since November, which is still promising for the dollar. Inflationary pressures also increased slightly last month as higher food and energy costs drove producer prices up 0.5% in May. Excluding food and energy PPI growth held steady at 1.7%. The current account deficit widened to -$106.1B from -$102.3B while foreign demand for U.S. dollars increased $12.7B in April. Unfortunately foreign investors were net sellers of long term U.S. Treasuries in April when 10-year bond yields fell from 1.85% to 1.65%. However we believe demand for dollars should have returned in May when yields spiked back up to 2%.

How Much Lower Can USD/JPY Fall?
Investors continued to liquidate out of short Yen positions, driving the currency pair to fresh lows against all of the majors. The biggest losses continue to be seen in the higher beta pairs, most significantly in AUD/JPY and NZD/JPY, both of which have fallen more than 2% Friday. USD/JPY dropped another 1.5%, putting it within striking distance of a fresh two-month low. The Japanese have only themselves to blame for not responding to the rise in JGB yields and decline in the Nikkei. If they want to calm the volatility in USD/JPY, they will need to take action. While we don't expect intervention from the BoJ, if USD/JPY drops to 92, we could start to hear some complaints about the excessively volatility in the currency. Part of the reason why the chance of intervention is still slim is because speculators are still not net long yen.The BoJ usually likes to see a buildup of short USD/JPY positions before intervening. Also, there's talk that exporters have set their USD/JPY hedges at 95, so there is very little panic at 94. At 90 or lower however, the chance of intervention is significantly higher. USD/JPY could still recover next week if Bernanke insists that they are thinking about tapering over the next few months. From a technical perspective, now that the key 95 level is broken, the next support is at 93.50, the 38.2% Fibonacci retracement of the 2012 to 2013 rally that took the pair from a low of 77.13 cents to a high above 103.75. Below that is the April 2013 swing low of 92.57. Japanese trade and current account numbers are scheduled for release next week along with the Ministry of Finance's weekly report on portfolio flows. The G8 Summit will be held in the middle of the week followed by a speech from BoJ Governor Kuroda at the end of the week. Abenomics will most likely be discussed but we do not anticipate any grand sweeping conclusions.

EUR: Stalls Ahead Of Key Inflection Point
The euro ended a strong week slightly lower against the U.S. dollar. We have reached some key inflection points in the major currencies and for the EUR/USD, a further rally will hinge on the outcome of the FOMC rate decision and euro-zone PMIs. When ECB President Draghi last spoke, he expressed optimism about the outlook for the Eurozone and this sentiment will be tested by this week's PMIs. If manufacturing and service sector activity increase as it is expected to, the EUR/USD to could extend to new three-month highs but if the data surprises to the downside, we could find the currency trading back down to 1.32. Aside from PMI, the German ZEW survey is also scheduled for release and with an Economics conference in Brussels and a Euro-area Finance Ministers meeting in Luxembourg, traders will also need to keep an eye on the headlines. Meanwhile in an interview Friday, Chancellor Angela Merkel acknowledged the investment community's concern on the financial transaction tax and said she will keep their concerns in mind when designing the tax law. There are concerns that the tax law will hurt pensions and dig the economy into a deeper recession. Merkel said, "We are aware of the fact because this tax is not introduced globally that it needs to be a tailor-made kind of tax that does not have the effect that you have described. That would obviously be a very bad thing to do." European Central Bank Governor Council member Christian Noyer said last month in Paris that the proposed tax may not generate any revenue because it might damage the market. Noyer said, once the tax is implemented it "will be either to destroy financial sectors" or create conditions in which "the cost of borrowing in the real economy will increase for everyone."

GBP: 3 Decade BoE Veteran Announces Resignation
Like the euro, the British pound also ended the strong week slightly lower against the U.S. dollar and higher against the euro. There were no U.K. economic reports scheduled for release Friday but Bank of England Deputy Governor Paul Tucker announced that he will stepping down after three decades at the central bank, making room for Mark Carney to nominate his own members to the monetary policy committee whose views may be aligned closer with his. U.K. Chancellor Osbourne's decision to elect Mark Carney as the next BoE head reveals his penchant for monetary activists suggesting that the person who will replace Tucker will be inclined to support monetary expansion. Carney who starts at the BoE in July is expected to be more aggressive than Mervyn King in trying to boost the economy, especially at the onset. He has said the central bank should help deliver "escape velocity" for their economies. Carney's had a spectacular track record during his time at the Bank of Canada. He reorganized the Bank of Canada by creating a financial stability department and improved coordination between economic, banking and financial market researchers. Next week will be a busy one for the U.K. On Tuesday the central bank will publish producer and consumer prices, the Monetary Policy Committee will release its latest meeting minutes on Wednesday and on Thursday retail sales data and CBI industrial order expectations will be announced.

CAD: Hit By Surprise Decline In Manufacturing Data
After a one day respite, the Australian, New Zealand and Canadian dollars resumed their slide against the greenback. No data was released from Australia but New Zealand's business PMI index surged to its highest level in nearly nine years, which should have been good news for the NZD. Unfortunately the currency shrugged off this report and instead fell victim to risk aversion. In Canada the sell-off in the loonie was supported by the 2.4% drop in Canadian manufacturing shipments. Shipments declined at the fastest rate in more than three years due to slower oil-refinery production and metal output. The Bank of Canada predicts that economic growth will shift to exports and investments from consumer and government spending. Petroleum and coal sales dropped 8.8%. According to the Statistics Canada, "Some refineries reported that either maintenance or the switch to summer fuels required production to be slowed or halted for a longer than normal periods." Sales excluding motor vehicles and parts declined 2.5%. Excluding price changes which is a strong indicator of growth, demand fell 1.6%. The dismal factory data suggest that the GDP may have contracted in April. Looking ahead, the RBA minutes are scheduled for release next week along with New Zealand GDP and Canadian retail sales.

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