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Dollar Retraces Friday’s Gains as Market Holiday Overrides Risk Sentiment

Dollar Retraces Friday’s Gains as Market Holiday Overrides Risk Sentiment

2010-05-31 21:10:00
John Kicklighter, Chief Currency Strategist
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Dollar Retraces Friday’s Gains as Market Holiday Overrides Risk Sentiment
Both the United States’ and United Kingdom’s markets were closed for public holidays Monday; but history has shown us that that does not necessarily preclude significant price action in the FX market. In fact, last week’s remarkably high level of volatility (though it was not accompanied by a distinct bearing for direction) would suggest thin liquidity to start the new trading period could leverage erratic and quick bursts of price action through the opening 24 hours of trade. Indeed we would see some notable swings from particular pairs and currencies; but this activity was more appropriately attributed to high-level event risk rather than market conditions themselves. What matters going forward is whether this break in time and activity will act to reset fundamental trends for the speculative markets or merely pass as a temporary lull. Recently, the dollar’s progress has been curbed as its primary source of support (safe haven flows fleeing the European Union’s debt troubles) has happened upon a period of equilibrium. However, the masses may not have yet truly responded to the news of Spain’s sovereign credit downgrade from this past Friday.  What’s more, geopolitical tensions were heightened this morning when Israeli Defense Forces boarded a ship carrying aid to Palestinians in the Gaza Strip and reportedly shot and killed a number of passengers when met with resistance. This adds to the finely balanced situation in North Korea. Given this much uncertainty in the world’s economic, financial and political health; a need for safety and liquidity makes sense.

In the event that investor sentiment does not pick up steam in the coming days, the US dollar will be left to fend for itself. Yet, when the benchmark’s appeal as a source of safety and stability is discounted, its implicit fundamental strength is tempered considerably. Match that to the fact that the single currency is just off of 14-month highs on a trade-weighted basis; and the case for an overbought condition is relatively easy to support. This leverages the importance of forthcoming event risk when it comes to not only maintaining the greenback’s advance but also keeping the currency from significantly retracing its gains. Undermining this effort today, Chicago Fed President Charles Evans (a non-voting member of the Board) remarked that the European fiscal troubles would likely delay the return to rate hikes for the American policy authority “just a little bit.” Adding to this, Philly Fed President Charles Plosser (who similarly doesn’t have a vote) commented that officials will dictate policy depending on how the European crisis impacts the US. This is a realistic warning (a true debt crisis in the EU could lead to a global liquidity problem); but traders hate hearing it regardless. Looking forward for scheduled event risk, Tuesday’s docket carries a notable market-mover in the ISM manufacturing activity report for May. However, given the level of other currencies’ data, this report may be overlooked.

Related: Discuss the US Dollar in the DailyFX Forum, US Dollar Awaits the Return of Liquidity, NFPs and the G-20 Meeting

Euro Suffers from Lax Inflation, Confidence Figures and Discord Over Expansionary Policy
Despite the lack of participation in the global financial markets from the Brits and Americans, the Europeans were dealing with a considerable level of fundamental activity Monday. Having not been able to properly react to Spain’ downgrade last Friday (as Fitch reported it near the market close), traders were watching closely to see how the securities would respond today. The Spanish IBEX 35 equities index fell a modest 0.7 percent and the benchmark 10-year government bond fell 0.35 percent of face value. This is a mute reaction; but it could easily reverberate when liquidity fills out Tuesday. The balance between staving off a regional financial crisis and capitulating to a sovereign moral hazard was argued today. Green ECB member Patrick Honohan threw in his support for the central bank’s new policy for purchasing government bonds to ease tension in the Union’s markets. However, his colleague Axel Weber maintained his criticism, suggesting it would invite “stability risks” and must be withdrawn as soon as possible. From financial crisis to event risk; today’s data offered little room for bullishness on the growth and interest rate front. While the Euro Zone’s CPI estimate would climb to a 17-month high 1.6 percent clip in May, the M3 money supply reading contracted once again. What’s more, economic confidence slipped for only the second time in 14 months. 

Canadian Dollar Starts its Rally with GDP, Looks to Extend the Move with a BoC Rate Hike
The Canadian dollar has not lacked for strength in the past year; but what has been the fundamental source of this appreciation? The Canadian economy weathered the global financial storm from 2007-2008 better than its major counterparts and growth would recover far more quickly than its international counterparts. Confirming that fact today, the annualized reading for 1Q GDP accelerated more quickly than expected to a 6.1 percent pace – the strongest clip in over a decade. However, growth still doesn’t account for the correlation the currency maintains with the high-yield Aussie dollar. Tomorrow’s BoC decision has the opportunity to change that. The market expected a 25bps hike and more to follow.

Australian Dollar Traders are Already Pricing in an RBA Pass but Could it Still Hurt the Currency?
Where the Canadian economy may be in the prime of its fundamental performance, Australia may have already plateaued. Of top concern is Tuesday morning’s RBA rate decision. The policy group led by Governor Glenn Stevens is expected to hold the benchmark after a round of almost unbroken hikes. If accompanied by the neutral commentary from May 4th, it could further the Aussie dollar’s retracement.

British Pound Traders More Concerned with Government Stability than Mixed Economic Data
Though the UK’s markets were close Monday, the fundamental waves would still ripple. For scheduled event risk, the annual Hometrack Housing Survey reading rose to a 28-month high 2.0 percent pace of expansion. However, this slow moving indicator would hold less influence than the political fallout from the resignation of the Chief Secretary to the Treasury. Political stability is essential for the pound at this point.

Japanese Yen Adds Political Uncertainty to Fiscal and Deflationary Troubles
Deflation already seems a semi-permanent state for the Japanese economy and the OECD’s forecasts for public debt to reach more than 200 percent of GDP have drawn unfavorable comparisons to Greece. As if this weren’t enough, the Social Democratic Party announced its break from the government’s three-way coalition. There is no clear fix for Japan; but adding political uncertainty certainly worsens the situation.

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**For a full list of upcoming event risk and past releases, go to www.dailyfx.com/calendar

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Written by: John Kicklighter, Currency Strategist for DailyFX.com
E-mail: jkicklighter@dailyfx.com

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.

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