- The pendulum swings back in the USD’s favor

- Timing of Fed/ECB rate moves is key to USD outlook

- G-8 focuses on inflation; supports USD recovery

- Mind the Range, please

The pendulum swings back in the USD’s favor

Two weeks ago, the USD surged on comments from Fed Chair Bernanke, sending the pendulum to the extreme side of USD strength. By the end of that week, however, the pendulum had swung all the way back to extreme USD weakness after the ECB indicated it is increasingly likely to raise rates at its July 3 meeting and the US unemployment rate unexpectedly surged. This past week saw the pendulum swing once more to the extreme side of USD strength on continued hawkish rhetoric from the Fed and some better than expected US data. This type of price action, while extreme and ultimately frustrating for break-out traders, is the essence of a range, which has been the defining feature of Forex markets over the last two months. Range conditions developed primarily because key central banks effectively moved to the sidelines in terms of adjusting interest rates. The Fed shifted from easing to steady, as did the Bank of England, while the ECB was caught between slowing growth and high inflation. Central bank interest rate expectations are now in flux and promise to make trading conditions extremely challenging in the weeks ahead. The predicament comes from the market’s rather extreme reaction to what may be only minimal interest rate moves. However, an end to the recent 1.53-1.58 EUR/USD range may finally be at hand.

Timing of Fed/ECB rate moves is key to USD outlook

In the US, while there is little debate that inflation is higher than the Fed wishes, growth is also extremely fragile and unemployment continues to drift higher. The Fed operates under a dual mandate of supporting both growth and price stability and the divergent paths of growth and inflation will keep the Fed walking a tightrope. Recent Fed rhetoric leaves little doubt they have shifted their focus from supporting growth to fighting inflation, but until concrete actions are taken, the Fed may only be starting an extended PR (public relations) campaign to contain inflation expectations. I think markets have over-reacted by pricing in 150 bps of tightening over the next year, and risks are that weaker than expected US data sees those bets reversed. Incoming US data will continue to drive near-term expectations, and that’s where traders should focus. Markets are pricing in a bit less than a 1 in 4 chance of the Fed hiking by 25 bps at its June 25 meeting, with the bulk not expecting any Fed moves until the Aug. 5 or Sept 18 meetings.

The extreme shifts higher in US Treasury yields are nothing less than astonishing and may represent a real turn in the US interest rate cycle. But we have been here before only to be hit by a bad dose of economic reality in the form of weaker than expected US data. This week sees the start of May housing market data, which has been the softest of the soft spots, along with June Phila. Fed and May LEI. Better than expected, or not as bad as feared, data can see the USD continue to gain, but weak or weaker data is likely to see the market second-guess future interest rate moves yet again, stalling the bucks test higher.

Contrast the US outlook of ‘potential’ rate hikes in 2-3 months time with the ECB’s shocking turn in favor of raising rates at its July 3 meeting. The catch here is that ECB Pres. Trichet has gone to great lengths to minimize the impact of a small adjustment in rates, so as not to leave the impression that it’s the beginning of a new tightening cycle. The net effect is to see the market discount the impact of an ECB rate hike, but that calls into question the point of raising rates at all. Doubtless the ECB is targeting firms and wage negotiators, but they are unlikely to drop demands for higher wages absent rapid declines in commodity prices and a restoration of consumer purchasing power.

My default view continues to be that the balance of weak US growth and higher inflation will see recent while range levels continue to hold. However, the case for a range break in favor of a higher USD is better than in many months, so I am prepared to go with a break this time. For a break-out to be justified, oil prices will need to see below $130/bbl and US Treasury yields will need to sustain gains. In light of Saudi comments last week on increasing supply, the downside in oil looks vulnerable, adding greater potential for a stronger USD.

G-8 focuses on inflation; supports USD recovery

This weekend saw the G-8 (G-7 plus Russia) finance ministers conclude a meeting in Osaka, Japan, where they set out the agenda for the G7 heads of state meeting in July. The primary outcome of the meeting was that the group focused on inflation as the greatest threat to global growth, pushing the credit crunch down the list of worries. The group does not issue a statement on currencies when central bank chiefs are not in attendance, but there were plenty of individual comments on FX, most supportive of a stronger USD. US Treasury Sec. Paulson once again re-iterated the strong-dollar mantra, which pleased French Fin. Min. Lagarde . Lagarde also said she suggested to Japanese Fin. Min. Nukaga that the JPY should appreciate versus the EUR. Russian Fin. Min. Kudrin noted that a stronger USD would likely arrest incessant oil and other commodity price gains. Taken together, the shift by the G8 to focus on commodity price inflation and the USD-supportive comments could set the stage for lower oil prices/higher USD to start this week. The JPY-crosses may also come under pressure if the market takes to heart Lagarde’s admonitions to the Japanese, but yields are more likely to drive the JPY at the end of the day.

Mind the Range, please

Going into this week, we are still confined to recent ranges in EUR/USD, GBP/USD, and USD/CHF, while USD/JPY, AUD/USD, USD/CAD and NZD/USD are all seeing the USD perform better. Against the European currencies, the key break-out levels to watch for a higher USD are daily closes below 1.5270/80 in EUR/USD, below 1.9350 in GBP/USD and above 1.0630 in USD/CHF. I would look for 250-350 pip follow-through moves initially (in the 48-72 hours after the requisite daily close) as reluctant USD-buyers are forced to reckon with a longer-term bottom for the greenback and finally step in and start buying. Candlestick price action at the end of last week leaves the impression that the USD’s gains may have already stalled, but other forms of technical analysis are more supportive of a higher USD.

The USD index finally posted a weekly close above the Ichimoku cloud (resistance zone) and EUR/USD finally made a weekly close below its cloud (support zone). With the exception of the AUD, which tested and held above the top of its cloud (support), the USD finished out last week above the Ichimoku clouds against all other currencies, suggesting a shift in trend for the USD may be unfolding. Daily ADX studies for the major USD pairs are all below ‘trending’ levels, suggesting range conditions continue to prevail, but DI+/DI- crossovers are all favoring the USD at the moment. The one exception is NZD/USD, whose ADX reading last week rose above 25, suggesting a trend is now in place, with the direction being lower.

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