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The “Go-to” Trade in FX Today

By Kathy Lien  and  Boris Schlossberg
16 May 2013 15:40 GMT

Although the strength and sustainability of the US dollar rally has come into question, the hottest trade on the market right now is shorting the Aussie versus USD, and even the institutions are piling in.

We have made it clear that we like the US dollar (USD) and think USDJPY is headed for a break of 103 and EURUSD down to 1.28. However, there are many skeptics out there who argue that the dollar doesn't deserve its current valuation, let alone further gains.

The skeptics’ reasoning has some merits, and we believe that eventually, the dollar rally will lose momentum, but if there's one thing we have learned about the FX market, it is that currency moves can become more exaggerated and out of line with fundamentals than most would anticipate. When the optimism reaches a peak, that's when the moves will reverse, and when that occurs, the correction can be brutal.

There are a few arguments floating around about why the dollar rally will not last. Some believe that the Federal Reserve isn't in a rush to taper asset purchases, and when the central bank finally decides to do so, it will not mean that they are headed for the exit.

At the last central bank meeting, the Fed indicated that it is open to increasing or reducing stimulus based upon incoming data, so they may opt to slow asset purchases modestly, then take a long break to see how the economy responds, and recalibrate as necessary.

While this is probably an accurate assessment of what the Fed will choose to do, if it comes at a time when the Eurozone is still in recession and the European Central Bank (ECB) is talking about increasing stimulus, it will still be positive for the dollar.

Other skeptics argue that the further the dollar appreciates, the more of a headache it provides for the US economy. They are also absolutely right, as a stronger currency presents headwinds for the export sector, but the US is not a trade-dependent economy and can therefore handle a stronger currency better than other countries.

The more direct implication of a strong currency is actually inflation. A stronger dollar lowers price pressures, which would give the Fed the flexibility to delay changes in monetary policy until they feel that the economy is ready.

Wednesday’s disappointing economic reports are good reasons why the Fed may want to wait. On Thursday, housing starts, building permits, jobless claims, and the Philadelphia Fed survey will provide a deeper look at how the economy has been performing.

While the skeptics’ arguments do have some merit, for the most part, we still believe that the relative outperformance of the US economy will keep the dollar bid.

The “Go-to” Trade in FX Today

It was a very quiet night of trade in the FX market with most majors staying within relatively tight ranges amidst little news flow, but the one exception to that was the Australian dollar (AUD), which hit fresh three-month lows today as the liquidation in the AUDUSD pair continues unabated. There was no fresh news out of Australia, but the pair tumbled through the 98.50 support level, stopping just shy of 98.00 before stabilizing a bit.

AUDUSD was hurt by the continuing slide in precious metals, as gold again dropped below $1400/oz., trading at $1370 in mid-morning London trade. The collapse of the Aussie has been unrelenting this month, with the pair falling on ten of the past 12 trading days. However, now that it is coming into longer-term support in the 97.00-98.00 region, the pair is likely to stabilize as longer-term investors step in to pick it up below par while attracted by its G20-leading yield.

"Short Aussie" has become the most obvious idea in the currency market with many large hedge funds piling into the trade. Investors expect the Reserve Bank of Australia (RBA) to continue to lower rates as the economy down under slows down both from curbing of commodity-related investment projects and declining exports to Japan—its second-largest market—as yen depreciation weighs on trade.

It is unclear whether the Australian economy will indeed seriously suffer from these trends. The latest labor market data showed a surprising resilience and flexibility as growth shifted from mining-related jobs to the service industry. Therefore, the prospect of further RBA rate cuts remains an open question, and if the central does not ease further, the Aussie could see a relief bounce over the next few weeks.

Euro Extends Losses as GDP Data Confirms Recession

The EURUSD dropped to its lowest level in more than a month on the back of disappointing GDP numbers. The Eurozone economy contracted for the sixth consecutive quarter with Germany seeing only 0.1% growth in the first three months of the year while France contracted by 0.2%. This left overall Eurozone growth at -0.2% for the first quarter, translating to a year-over-year contraction of 1%.

In other words, the Eurozone is still in recession, and for this reason alone, the EURUSD deserves its current valuation. Continued weakness in the Eurozone will only make the European Central Bank more inclined to increase stimulus or at least become more vocal about the possibility.

In the coming days, we expect ECB policymakers to remind the market that negative deposit rates or purchases of asset-backed securities are on the table, and when they do, the EURUSD could extend its losses.

It is also worth mentioning that EURCHF rose to its highest level since the Swiss National Bank (SNB) put a floor under the currency pair in 2011. However, the pair failed to hold on to its gains even after shrugging off a surprise increase in producer prices.

USD/JPY Eyes Move to 103

USDJPY held onto its gains on Wednesday even after the disappointing US economic data. Overnight, Japanese GDP data surprised to the upside, printing at 0.9% versus 0.2% expected, an encouraging development that suggests the nation’s “Abenomics” is starting to work.

Japan's Industrial production also perked up, and demand is clearly expanding in the wake of highly stimulative policies by the Bank of Japan (BoJ). The USDJPY rose back above the 102.50 level as currency markets were encouraged by the news, and the pair could target the key 103.00 figure if US flows prove supportive in today’s North American session.

The Dollar’s Strongest FX Counterpart

Compared to many of the other major currencies, the British pound (GBP) has held up well against the dollar and even managed to tack on gains against the euro. UK economic data continued to beat expectations with jobless claims falling 7.3k in the month of April compared to a forecasted decline of 3k. Average weekly wage growth slowed, but any negative sentiment was offset by the higher GDP and lower inflation forecasts from the Bank of England (BoE).

This is the best of both worlds for the central bank because lower inflationary pressures allow them to keep monetary policy accommodative to support growth. This is the first time since the Financial Crisis that the BoE upgraded their growth forecasts. They now expect 2013 growth to hit 1.2%, up from their prior forecast of 0.9%.

However, a large part of this upgrade was due to stronger growth in the first half of the year as the BoE cut second-half forecasts. In terms of inflation, the central bank now believes that consumer prices will drop to their 2% target in the third quarter of 2015 instead of the first quarter of 2016.

This is the last quarterly inflation report to be signed off by Bank of England Governor Mervyn King. When incoming Governor Mark Carney takes office in June, he may take a different approach and opt for easier monetary policy since he's been tasked with jumpstarting the UK economy.

By Kathy Lien and Boris Schlossberg of BK Asset Management

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.
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16 May 2013 15:40 GMT