What Does S&P's Upgrade Mean For The USD?

It was a mixed day for the U.S. dollar, which recovered sharply against the Japanese Yen, traded mildly higher against the Australian dollar and lower against the European currencies. The front of this week is extremely quiet in terms of U.S. data leaving investors with only speeches by Federal Reserve Presidents and action by rating agencies to react to. So even though S&P's upgrade to its outlook for the U.S. credit rating does not have a fundamental impact on the outlook for the U.S. economy or the dollar, it made investors feel more secure about their long dollar positions and helped the greenback sustain its gain against the Japanese Yen.

According to the rating agency, who cut the U.S.' AAA rating to AA+ two years ago, receding fiscal risks prompted them to upgrade the U.S. credit outlook to stable from negative. Previously, the S&P was worried about the political gridlock that threatened to force the U.S. economy over the fiscal cliff but now they see "tentative improvements on two fronts. On the political side, Republicans and Democrats did reach a deal to smooth the year-end-2012 "fiscal cliff", and this deal did result in some fiscal tightening beyond that envisaged in BCA11, by allowing previous tax cuts to expire on high-income earners.........Aside from tax hikes and expenditure cuts, stronger-than-expected private-sector contributions to economic growth, combined with increased remittances to the government by the government-sponsored enterprises (reflecting some recovery in the housing market), have led the Congressional Budget Office (CBO), last month, to revise down its estimates for future government deficits. The stable outlook indicates our appraisal that some of the downside risks to our 'AA+' rating on the U.S. have receded to the point that the likelihood that we will lower the rating in the near term is less than one in three. We do not see material risks to our favorable view of the flexibility and efficacy of U.S. monetary policy. We believe the U.S. economic performance will match or exceed its peers' in the coming years. We forecast that the external position of the U.S. on a flow basis will not deteriorate."

However don't expect the S&P to upgrade the U.S.' rating anytime soon. They were quick to say that no country has recouped its AAA status in fewer than nine years. Nonetheless U.S. bond yields ticked higher, which supports the rally in the dollar but for the most part, we don't expect Monday's decision by S&P to have meaningful impact on the market's appetite for the greenback. Meanwhile comments from Fed President and FOMC voter Bullard suggest that he doesn't support tapering asset purchases. Bullard said inflation surprised to the downside and as such could warrant prolonging QE. U.S. growth is steady but unspectacular and only an improving labor market would warrant slower asset purchases. These moderate comments capped the gains in the dollar as investors continue to look for clues on how the likelihood of the Fed tapering asset purchases this year.

JPY: What To Expect From The BoJ
The Japanese Yen traded lower against all of the major currencies ahead of Monday evening's Bank of Japan monetary policy announcement. While USD/JPY has rebounded as much as 400 pips from its low, many traders are still wondering whether 103.74 is the top in USD/JPY. The answer to this question lies in whether the fundamentals factors that have driven USD/JPY higher since November have changed. There is no question that we have seen a significant amount of deleveraging in the equity and bond markets and some of the assumptions about the implications of Abenomics have not transpired, the most important of which is un-hedged Japanese foreign investment. The message from the Japanese has also been confusing with the Bank of Japan setting up the market for a long period of aggressive bond purchases (hence long USD/JPY trades) but then warning about the risks of inflation. Prime Minister Abe also failed to introduce new prescriptions to fix economy when he unveiled his latest policy agenda to everyone's disappointment.

At the same time, the slide in U.S. stocks and uncertainty about Fed tapering caused widespread deleveraging that led investors to cut their long dollar positions. In turn, investors have been rethinking the impact of Abenomics. The next few percentage point moves in USD/JPY will be determined by the direction of U.S. and Japanese monetary policy, both of which have caused uncertainty in recent weeks. Investors are still trying to figure out how serious the Federal Reserve is about tapering asset purchases this year and this week's retail sales report will help shape expectations. Unless there is a big surprise in retail sales however, the outcome of Tuesday's Bank of Japan decision should have the larger impact on USD/JPY. The best case scenario for USD/JPY is if the BoJ extends the maximum duration of its funds supply operation from one-to-two years and increases the frequency of bonds purchased. Given the sharp decline in the Nikkei and the volatility in the Yen, we suspect that the central bank will be eager to stabilize the markets. However there have also been improvements in economic data and the BoJ Governor previously criticized successive policy actions, which means he could do nothing more than an operational tweak on the maximum duration of their funds supply operation which would be a disappointment for USD/JPY. The worst case scenario for USD/JPY would be if U.S. retail sales missed expectations and the Bank of Japan failed to deliver.

EUR Extends Gains, Encouraging Comments From Draghi
The euro extended its gains against the U.S. dollar but failed to make new highs. European Central Bank President Draghi spoke earlier this morning and his comments contributed to the rise in the currency. The head of central bank said the ECB bought fewer bonds than any other central bank, which implies that they are not easing monetary policy as aggressively as some of their global counterparts. He also said the risk for German tax payers have fallen significantly from a year ago and noted that the central bank won't generally act to save a country's solvency. His comments about rates rising when there is confidence in an economic recovery confirms that the central bank's outlook for the euro-zone economy has brightened. There's not much in the way of euro-zone data this week to confirm or deny the central bank's views, leaving the outlook for EUR/USD largely dependent on U.S. data at the end of the week. For the most part we expect the EUR/USD to hold onto its gains as we have seen some signs of improvement such as French industrial production, which rebounded strongly. Meanwhile the Swiss Franc ignored better than expected economic data. Switzerland's unemployment rate dropped to 3.0% from 3.1% in May and retail sales jumped 3.3%. These improvements could also be a reflection of a recovery in trade activity with the euro zone. The German Constitutional Court also rules on the constitutionality of Outright monetary purchases Tuesday, which could affect how the euro trades.

AUD Hits Fresh Lows -- Still No Bottom In Sight
There was very little consistency in the price action of the commodity currencies. The Australian dollar dropped to a fresh one year low, the New Zealand dollar rebounded and the Canadian dollar held steady against the greenback. Over the weekend, Chinese economic data surprised to the downside with industrial production growth slowing. This is terrible news for Australia who could be negatively affected by weaker Chinese resource demand. The pressure on the AUD has been very strong and so far, there appears to be no signs of abating. This week we have a number of important Australian economic reports that will affect how the A$ trades but we are not sure if any of these reports will be powerful enough to alter the trend in the currency. Nonetheless with the A$ in deeply oversold territory a few pieces of good news could still trigger short covering but a serious reversal of the downtrend in the AUD/USD would require a shift in rhetoric by the Reserve Bank of Australia or sudden weakness in U.S. data. In the meantime, we have Australian home loans and business confidence due for release this evening. Across the Pacific, Canada continued to report better than expected data with housing starts rising at its fastest pace in 13 months. The benefit to the CAD against the dollar may have been limited but we are seeing stronger CAD gains against the crosses.

GBP: Expect Trend Of Good Data To Continue
The British pound ended the day virtually unchanged against the U.S. dollar and euro. No U.K. economic reports were released this morning but according to a survey by BDO LLP out Monday, there is further evidence that the UK economy is recovering. Their measure of employment intentions rose to 96.6 from 94.4, company output expectations increased to 94.4 and business confidence index rose to 93.6. Inflation expectations also rose to 104.2 from 103.4. Peter Hemington from BDO commented saying that, "It's encouraging to see that UK business confidence has continued its upward trend, and that businesses have retained their healthy hiring intentions. However the government must do more to achieve the robust economic growth that remains tantalizing out of reach. The government must look to ensure more funds are reaching British businesses through lending, in order to help them drive the UK's economic recovery." Last week, we saw a trifecta of improvements in the U.K. economy with manufacturing, service and construction sector activity accelerating. We expect these upside surprises in U.K. data to continue this week starting with Monday night's RICS house price balance and Tuesday's industrial production reports. The U.K. housing market has been very strong led by gains in London and manufacturing activity according to the latest PMI report. Good data could finally drive the GBP/USD to close above 1.56.

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