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Fed attempts to bolster USD, ECB flummoxes
The new month got off to a rollicking start (yes, I’m being sarcastic) with Fed Chair Bernanke on Tuesday addressing USD weakness in prepared remarks to the International Monetary Conference. Bernanke explicitly noted that the Fed, “in collaboration with our colleagues at the Treasury,” was carefully monitoring currency markets, the important points being that Treasury was included and that the weak USD was on the Fed’s radar screen. Bernanke noted that USD weakness had an impact on inflation and inflation expectations and voiced a preference for a “strong and stable dollar.” His remarks caught the market off guard, but his message was ultimately deemed to be potentially significant by many market participants and a USD buying spree ensued. By early Thursday morning, the USD was on the verge of breaking higher, with the USD index breaking up over trendline resistance dating back to last August, and higher out of the Ichimoku cloud. But the moves were not to last.

On Thursday morning, just after better than expected weekly jobless claims saw the USD push to new highs below 1.5400 EUR/USD, ECB Pres. Trichet began his press conference with hawkish rhetoric warning that greater inflation risks prevailed. Before he finished, Trichet would drop the bombshell that the ECB was very likely to raise rates at the July ECB meeting, which markets had not been expecting. Over the next few hours EUR/USD soared from 1.54 to finish the day near 1.56 on massive short-covering from a thoroughly confused market. The icing on the cake came on Friday with weaker than expected May NFP employment data out of the US, adding USD selling pressure to EUR buying pressure. EUR/USD pressed higher to within reach of recent highs at 1.5800/20 by Friday afternoon. But the lasting impression in the Forex markets was one of a lack of policy coordination across the Atlantic on USD weakness/EUR strength and leaving the Fed exposed to credibility issues. The higher interest rate signal from the ECB, with its implications for EUR strength, suggests the ECB may now be more willing to tolerate a higher EUR than previously thought.

This is a dramatic time in currency markets, as markets were slowly coming around to the view that the USD had likely bottomed, and while unlikely to rally sharply, would at least stop weakening. Those expectations are now seriously damaged and the potential for a crisis of confidence in the USD is rising as a result. There are many variables at work, not the least of which is that an ECB rate hike is not a done deal yet, though comments from ECB officials Weber and Bini-Smaghi on Friday suggested it was. Trichet suggested any rate hike would be ‘small,’ leaving the impression that it would be a one-time hike rather than the start of a new tightening cycle. From the US side, we have numerous Fed speakers on tap next week, including NY Fed Pres. Geithner and Chairman Bernanke, along with Treasury Sec. Paulson, who will have an opportunity to echo and/or amplify their commitment to preventing further USD weakness. The big question, though, is whether Forex markets will buy into US efforts to support the USD again absent concrete action in the form of higher US interest rates or market intervention.

We are on the cusp of a renewed phase of USD weakness, exacerbated by spiking oil prices and weaker labor reports. There are reasons to believe that oil price gains might be based on short-term positioning moves, but the trend has been relentless. Traders need to reckon with fresh USD weakness if the recent double top at 1.5810/20 is broken on a closing basis. Perceptions of 1.60 as the maximum EUR/USD level have been severely weakened after the ECB’s rate shift, and the feeling is growing that the ECB might be prepared to allow for a higher EUR as another way to combat inflation, so strength beyond 1.60 may still be in the cards.

May NFP reveals the glass is half empty
Markets have been wavering over the extent of the US economic downturn, with many suggesting it will be shallow and brief (glass half full) and the rest concerned that it will be deeper and longer (glass half empty). Friday’s May employment report poked a hole in the bottom of the glass as it showed deteriorating labor markets coupled with an increase in job seekers, leading to the 0.5% increase in the unemployment rate. The headline number registered a NFP jobs loss of -49K, but the underlying details suggested greater weakness on the order of -132K. The service sector continued to shed cyclical jobs at an elevated rate, led by declines in temporary workers (a leading indicator for employment cycles) and retail trade, suggesting consumer spending is still contracting. The increase in job seekers can partly be attributed to students entering the labor force, but more likely it suggests strained households seeking another job to help make ends meet.

The sharp jump in the unemployment rate also makes it more difficult, at least politically, for the Fed to raise rates any time soon, removing another potential crutch for the USD. Only inflation remains as a realistic justification for higher rates, but then we’re heading down the path of stagflation and likely prolonging the US downturn. As far as the USD is concerned, there are not a lot of attractive options outside of verbal intervention and outright market intervention. Should the USD decline begin to unravel and become disorderly (2-3%/day), along with other financial markets collapsing, market intervention by the Fed & Treasury becomes more likely.

Bank of Canada rate decision on Tuesday
The Bank of Canada is on deck to meet next week and make its decision on interest rates. The market is expecting a 25 basis point cut to 2.75%, but the risk of a 50 bps move is palpable. Continued weakness in US economic data is seemingly having an impact on Canadian growth, given the linkages between both countries. This showed through loud and clear a week ago when Canada reported an unexpected decline in 1Q GDP. Moreover, inflation in Canada remains extremely benign with consumer prices excluding food and energy running at a 1.1% annual rate. Given that the BOC’s inflation target is 2%, they clearly have room to cut interest rates without fueling inflation beyond the desired level. With similarly weak economic prospects for both the US and Canada and the recent rally in USD/CAD to one month highs near 1.0220, we would not expect a significant move higher in USD/CAD on the back of the BOC’s rate cut. Against other currencies, however, the Loonie is fair play. CAD/JPY could easily see below trendline support at 102.90 towards 102.50 on a 50 bps cut from the BOC.

Update from Downunder (AUD & NZD)
Kiwi took it on the chin this week as comments from central bank Governor Bollard suggesting a probable rate cut at the next RBNZ meeting caught the market off guard. Bollard said flatly that the bank’s “forecast is consistent with the possibility of a rate cut in the third quarter”. NZD/USD was trading around the 0.7800 figure prior to the news and had dropped more than 180 pips on the surprise comments by the time NY trading started on Thursday. Some market participants expect the New Zealand economy is in recession in 2Q and look for more than 200 basis points in rate cuts through the end of 2009 as economic growth continues to slow and terms of trade weaken on declining dairy prices. This is likely to continue to weigh on NZD/USD and we expect that while below the 0.7700 level the focus remains to the downside. A break back below Thursday’s lows near 0.7615 sees daily trendline support near 0.7580/70.

Aussie fared much better on the week with the RBA leaving rates unchanged and suggesting that elevated inflation pressures could lead to an increase in the very near future. The consensus is that Australia needs to combat unacceptably high inflation that threatens economic growth. A much better than expected 1Q GDP result also propped up Aussie. Growth doubled expectations, coming in at 0.6% QoQ following an upwardly revised 0.7% in 4Q. The fact that the economy seems to be on good footing gives the RBA leeway to fight inflation. Indeed, the market now expects the RBA to raise rates by more than 30 bps in the next 12 months. Add to this the recent surge in commodity prices, which rose nearly 5% this week alone, and the fundamentals are there for a push higher in Aussie. AUD/USD opened the week near 0.9560 and was trading near the all-time high daily close of 0.9629 towards the end of the NY session. A break above the recent intraday highs and hourly trendline resistance near 0.9650/60 sees more upside potential for AUD/USD in our view.