USD Selloff Blamed On Deleveraging

The sell-off in the U.S. dollar, Monday, can be best described as another case of deleveraging. The greenback fell aggressively after U.S. economic data surprised to the downside, giving investors more reason to reduce their positioning. Last Friday's decline in U.S. stocks and the complete breakdown in Japanese equities have made investors nervous. There hasn't been an all out collapse or reversal of recent gains (stocks ended slightly higher Monday), but the market's struggle to avoid a deeper correction and rally has made investors worried about a potential top in equities. Since U.S. dollars were bought throughout the rally, it has been now sold as investors cut their overall exposure.

The breakdown in the greenback drove USD/JPY below 100, the EUR/USD above 1.30 and the AUD/USD above 97 cents. While a slowdown in service sector activity accompanied by a decline in job growth is needed for the Federal Reserve to reconsider its plans to dial back asset purchases, the deterioration in manufacturing sector activity is definitely not what the central bank or the market wanted to see. The ISM manufacturing index dropped to 49.0 from 50.7 last month as manufacturing activity contracted at its fastest pace in four years. Equity and bond traders weren't fazed by the report like currency traders but this misalignment between financial market performance and economic data is one that investors should watch very carefully. There's a tremendous amount of key U.S. economic reports on the calendar this week and if they all surprise to the downside, it will be hard for the Fed to convince the market that asset purchases will be tapered in the coming months.

No U.S. economic reports are scheduled for release Tuesday but the abundance of data expected on Wednesday will keep the U.S. dollar in focus. Both USD/JPY and the EUR/USD could take a break before extending their latest moves as we saw Monday, it didn't take much to trigger additional deleveraging in the markets so traders need to an eye on key levels. As long as U.S. stocks don't crash, any decline in the dollar will be slow but if stocks see another day like Friday, then USD/JPY could find itself at 98 and the EUR/USD at 1.32.

Will The RBA Save The AUD?
Over the next 24 hours, the Australian dollar will be a central focus for FX traders because of the Reserve Bank of Australia's monetary policy announcement. The AUD staged a very strong rally against all major currencies, rising more than 2% against the U.S. dollar and over 1% against the euro. Better than expected Australian and Chinese data played a large role in the currency's rally but U.S. dollar weakness drove the AUD/USD above 97 cents. The RBA meets Monday night and we believe that their outlook for Australia's economy could compound the gains in the AUD. The last time they met, they cut interest rates by 25bp, citing the strength of the Australian dollar as a primary motivation for their decision. Since then, the AUD has plunged as much as 9% and is currently down 7.5% against the U.S. dollar. We are also starting to see some improvements in the Australian and Chinese economies with data from the manufacturing sector data surprising to the upside for both countries. Australia's PMI manufacturing index jumped from 36.7 to 43.8 last month. While retail sales fell short of expectations it still rebounded from the month prior. As a result, we believe the RBA could shift to neutral as the lower currency provides its own source of stimulus for the economy. If we are right, optimistic comments could extend the rally in AUD/USD. However if the RBA remains dovish and concerned about downside risks, Monday's gains could melt like ice cubes in your hand. The New Zealand and Canadian dollars also performed well despite the lack of domestic data. This was due in part to the rebound in commodity prices -- gold and oil are each up about 1.5%.

USD/JPY Breaks 100
USD/JPY may not have seen the biggest move Monday but its break of 100 was the biggest headline. After spending about three weeks above this key level, the series of lower highs and lower lows made it seem that a break was inevitable and Monday's disappointing U.S. ISM report was the straw that broke USD/JPY's back, driving the currency to a low of 98.97. We continue to be amazed by the ability of European and U.S. investors to ignore the ongoing deleveraging in Tokyo. The Nikkei dropped another 3.7% overnight putting their total losses at 15% over the past two weeks. If the S&P 500 dropped 15%, everyone would be screaming that the bull market is over and stocks around the world would decline but so far we haven't seen much contagion and we are worried that we will soon. Yet despite our concerns we have to acknowledge that U.S. markets continue to perform well with the Dow Jones Industrial Average recovering 50% of Friday's losses. Between the volatility in the Yen and the Japanese equity and bond markets, the Bank of Japan who meets next week may realistically consider increasing the frequency of assets purchases just to renew the rallies.

Will The ECB Alter The Playing Field?
The euro traded sharply higher, breaking above 1.30 after U.S. economic data surprised to the downside. Perhaps the tides are shifting with European data improving and U.S. data deteriorating. As we have seen in this morning's euro zone manufacturing PMI numbers, the outlook for Europe is brightening. The manufacturing sector did not contract as much as initially reported in the month of May. The index was revised up from 48.8 to 48.3 a 14 month high with improvements seen in both Germany and France. On Sunday, we heard some cautiously optimistic comments from ECB President Draghi that were later confirmed by the PMI reports. He said, there are "few signs of possible stabilization" in the euro zone and they expect a "very gradual recovery" later this year. With the central bank gearing up to meet this week, these comments could be Draghi's way of setting expectations for more a moderate and less pessimistic outlook on Thursday. When the ECB last met, they doled out a big dose of easing by cutting their main refinancing rate by 25bp, their lending rate by 50bp and extending their fixed rate allotment until July of next year. On top of that they said they were willing to consider negative deposit rates. Draghi used the word weaker countless times in his introductory statement to describe the economy, said he was very worried about the labor market and warned that the weakness in growth expanded beyond the peripheral to core economies. His talk about stabilization and recovery on Sunday suggests that the central bank will not be nearly as grim which could alter the playing field for the EUR. Negative deposit rates are still on the table but we feel that the economy needs to deteriorate more significantly or European markets need to see additional volatility for the ECB to resort to this option.

GBP: Could Hit 3-Month High Against EUR
The British pound traded higher against the U.S. dollar and euro following better than expected manufacturing PMI numbers. According to the latest report, manufacturing activity increased at a faster pace in the month of May and what made the numbers even more positive for sterling was the upward revision in April. Originally, a contraction was reported but now we learned that the sector grew slightly in the first month of the quarter. The third straight month of improvement should ease the concerns for the Bank of England who meets later this week. At this point, there is almost zero chance of a move by the BoE, which means that Thursday's meeting will most likely be a nonevent for the GBP/USD. While there may still be a bias for more stimulus, as long as the economy improves, there will be limited urgency. The BRC's retail sales report is scheduled for release this evening along with PMI construction on Tuesday. These secondary reports are not expected to be big market movers for the currency pair and so the sustainability of gains in the GBP/USD will hinge on the market's appetite for U.S. dollars.

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