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Stunning Reversals Shock the FX World

Stunning Reversals Shock the FX World

Boris Schlossberg and Kathy Lien,

Extreme volatility and sudden reversals have hit world currency and equity markets, and the US dollar has now surrendered recent gains and suffered a massive selloff against the Japanese yen.

In what was a very volatile day, the US dollar (USD) and US stocks made a complete U-turn in the last two hours of North American tradingon Wednesday, shifting lower very quickly. The selloff in the financial markets coincided with the release of the Federal Open Market Committee (FOMC) meeting minutes, but what was interesting above the move was that traders had a very different reaction to Fed Chairman Ben Bernanke's testimony earlier in the day and the late-day Fed minutes even though the underlying implications of both were the same.

Early Wednesday, the dollar and US equities soared after Bernanke said the Fed could cut the pace of asset purchases in the next few meetings. Investors focused on his optimism even though a reduction in asset purchases would mean that the central bank is taking the punchbowl away, which should be negative for equities.

However, when the Fed minutes confirmed that the central bank is having a lively discussion about slowing asset purchases, the S&P 500 gave back all of its early gains to end the day down 0.83%. The dollar also followed lower even though fewer asset purchases would be positive for the greenback.

The only market that had a consistent and logical reaction was Treasuries. Ten-year Treasury yields rose above 2% for the first time in two months, which suggests that the pullback in USDJPY should only be temporary.

According to the Fed minutes, there's still a wide division within the central bank with some members calling for the Fed to dial back quantitative easing (QE) measures as early as June. However, the majority still believes that more progress is needed before changes can be made. This is consistent with the message from Bernanke and New York Fed President William Dudley, both of whom suggested that a reduction in bond purchases is a few months away.

The USDJPY rose to a 4.5-year high of 103.73 on Wednesday, and as long as US Treasury yields continue to increase, we expect the currency pair to make new highs.

On Thursday, the US economic calendar will feature jobless claims, the house price index, and new home sales reports.

Nikkei Triggers Massive USD/JPY Selloff

A more-than-7% plunge in the Nikkei overnight triggered a massive selloff in USDJPYwith the pair tumbling more than 250 points from the highs of the Asian session before finally finding some support near the 101.00 level. The Nikkei fell very hard as profit taking and investor concerns over the volatility in the Japanese government bond (JGB) market sent shares tumbling, creating a massive risk-off environment that reverberated throughout the night.

The JGB market has been the Achilles heel for the Bank of Japan (BoJ), as rates have become much more volatile since the start of the Bank’s massive liquidity program. This new turbulence has spooked investors and resulted in the worst selloff in the Nikkei in several years. The plunge was precipitated by small investors, whose participation has steadily increased over the past several months, during which the Nikkei climbed to fresh multi-year highs.

The drop in USDJPY was also driven by weaker-than-expected Chinese manufacturing data, which dropped below the key 50 boom/bust line, suggesting that the sector is contracting for the first time this year. The pair has been grossly overbought and was due for a correction, and despite the market's assessment of Fed Chairman Ben Bernanke’s testimony about QE, we continue to believe that the prospect of tapering asset purchases is slim to none for the foreseeable future as long as the US economy shows signs of slowing.

Euro Gains as Profit-Taking Sets in

The euro (EUR) fell aggressively alongside other major currencies against the US dollar, but even with the rally, the EURUSD continues to hold above 1.28, a level that has supported the currency pair since the beginning of April. Whether this level will continue to hold, however, depends on Thursday's PMI reports and the speech from European Central Bank (ECB) President Mario Draghi.

A large part of the recent euro selloff was caused by concerns regarding the health of the Eurozone economy. Because the region is in recession, the ECB felt the need to ease monetary policy, but overnight, EURUSD got a boost from slightly better flash PMI data with the EZ Composite coming in at 47.7 versus 47.2 expected.

The index remains deep in contractionary territory, but the sense of stability provided hope that worst may be over for the region, and growth may begin to improve into the summer months. The EURUSD bounced back to 1.2900 on overall dollar weakness and could target the 1.2950 level later Thursday if the profit-taking rally continues.

How much of a recovery (if at all) the euro will enjoy will depend on what ECB President Draghi says in his speech, "The Future of Europe in the Global Economy." In the interest of preventing the euro from recovering sharply, we believe that Draghi will remind the market the ECB is still thinking about negative interest rates and buying asset-backed securities (ABS). Although the bar may be high, a weak euro helps the central bank's efforts to stimulate the economy, and the ECB will look to hold onto any and all support it can get for the economy.

A number of other Eurozone policymakers will also be speaking on Thursday, so keep your eyes on the newswires.

British Pound (GBP) Crushed by New Data

The British pound (GBP) sold off aggressively against the euro and US dollar following disappointing economic data and dovish Bank of England (BoE) meeting minutes. First-quarter GDP numbers are expected Thursday, and while the recent improvement in trade activity and rise in retail sales in the first three months of the year should boost growth, sterling may not see much benefit from a stronger number as investors overweight more recent data.

Sterling hit a one-month low today after UK retail sales dropped 1.3% in the month of April. This pullback in spending took the market by complete surprise, as economists were looking for a flat reading, and the sticker shock of the release should keep the currency weak.

Commodity Dollars Dropping Like Rocks

Once again, the Australian dollar (AUD), New Zealand dollar (NZD), and Canadian dollar (CAD) all sold off aggressively against the greenback. The recent weakness has taken the AUD and CAD to their lowest levels in 11 months and the NZD to its lowest level in 8 months. While New Zealand's economy is probably the strongest, its currency has been hit the hardest on a day-to-day basis.

The decline in commodity prices is contributing to the pressure on the commodity currencies, especially the AUD, which has fallen in lockstep with gold prices. Unfortunately, the recent rate cut by the ReserveBank of Australia (RBA) and the rise in Australian stocks has not made Australians feel any better about the outlook for the economy. According to Westpac, consumer confidence dropped 7% this month, the largest decline in 17 months.

Consumer demand in Canada is also anemic, contributing to the weakness in the loonie. Retail sales were flat in March after growing 0.7% in February, and excluding autos, sales declined 0.2%.

While no major economic reports were expected from the commodity-producing countries overnight, the AUD, NZD, and CAD could still endure big moves on the back of Chinese manufacturing numbers.

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.