Dollar Strength Not As Consistent As EUR/USD Tumble Suggests

EUR/USD posted its biggest daily drop (130 pips or 1.0 percent) since January 3 – when the greenback responded to the last minute Fiscal Cliff deal. If the world’s most liquid currency cross is showing significant dollar strength, the benchmark most be outperforming the market…right? In fact, the greenback’s performance wasn’t as awe-inspiring as its benchmark pairing would suggest. Most of the majors put in for relative restrained performances – with the exception of the biggest USD/JPY drop in nearly three years (more on that below). For the Dow Jones FXCM Dollar Index (USDollar), the uneven performance translated into a sparse 2 point advance – though still the highest close since September 2010. That being said, volatility for the index was far more remarkable than the day-to-day move. The dollar-favorable gaps for USD/JPY and GBP/USD on the open drove the index to 10,445. Subsequently, the strong collapse of the yen crosses would have to be offset by EUR/USD’s performance to promote stability. As discussed in the weekly fundamentals, USD/JPY can be a serious dollar hamper.

Moving forward, the dollar’s performance depends on the emergence of a persistent and lasting risk aversion theme. Though the opening session, volatility stoked genuine fear for FX traders and leveraged the greenback’s recently-diminished reserve appeal. The FX Volatility Index (FX VIX) extended its steady advance to an eight-month high while the equity-based VIX Index posted an incredible 34 percent surge – one of the biggest in decades. A jolt of panic caters to the dollar’s appeal; but to keep the greenback well bid should risk aversion kick in and direct capital towards the yen on carry unwind, we need persistence and perhaps an inherent bullish factor. It is unlikely, but if Fed Chairman Bernanke discusses an eventual exit from QE before the end of 2013 in his testimony Tuesday, it could be a two-pronged driver.

Euro Tumbles Versus Dollar, Yen and Pound During Italian Election
In a volatile day for the currency markets, the euro was the weakest of the majors. Initially, the shared currency opened the weak on a relatively firm footing; but that quickly fell apart as headlines devolved on the Italian election results. The first leg of the euro’s opening performance was a response to a sound win for a pro-austerity, pro-euro Nicos Anastasiades as the Cyprus’ president. While this far from resolves the issues the small island-nation faces – which draw suspicious comparisons to Greece – it does relieve it as an immediate threat. With that election out of the way, the focus turned to the far-more critical Italian election. The possibility of an outright win for an individual party never really seemed to catch, but there was some tentative expectation that a pro-euro coalition could be made. That was dashed, however, as the count continued. Now, with the vote essentially over, there is no clear winner which necessitates either a grand coalition or a reelection. Furthermore, the anti-austerity groups seemed to gain considerable traction – voters clearly showing their frustration over a deepening recession. A full resolution to Italy’s election issues may not be cleared up for a few weeks. In the meantime, speculators will start to fret over the renewed fear of fiscal tension in the Euro-area will do to bond yields. If the debt market locks up, the ECB may have to reverse its contracting balance sheet.

Japanese Yen Posts Biggest Rally Since May 2010Volatility from the Japanese yen Monday was simply incredible. USDJPY put in for its biggest dailydrop since May 2010 while EURJPY (leveraged by the euro’s troubles) carved an astounding 659-pip range through the same period. This activity level is extreme; and interestingly enough, didn’t seem to fit the fundamental developments through the session. The trading weak actually started out with a sizable gap to the upside on yen crosses. This yen drop was a response to news that there was a favored candidateto take the Bank of Japan helm by the name of Haruhiko Kuroda. With an illustrious career in the finance world, the candidate is a known advocate for beating deflation and implementing a 2 percent inflation target in a relatively short time frame. For FX traders, this means a man willing to raise the stakes for intervention. Yet, we have long-known the next BoJ leader will be more prone to easing. And so, the initial move was reversed. But with both waves, volatility was leveraged. Volatility is a fragile carry trade’s kryptonite. If risk aversion truly kicks in, the yen rally will build steam. If not, back to stimulus.

British Pound: Was the UK Downgrade Gap the End of the Plunge?
GBPUSD opened the week with a notable, 34-pip gap to the downside. Other sterling-based crosses produced bigger disparities with the beginning of official trade Monday. The sharp move down was the first opportunity for many to react to the Moody’s rating agency’s downgrade of the United Kingdom’s AAA-rating late Friday evening. This downgrade certainly undermines Prime Minister Cameron’s effort to balance his austerity push while warding off recession (already a losing fight), but it was priced in. Now the question is the BoE’s appetite for stimulus.

Australian Dollar Little Concerned with RBA Members Intervention Threat
It seems everyone is getting into the verbal intervention game – even though the G20 expressly assured us that the world’s developed nations wouldn’t engage. RBA Deputy Governor Guy Debelle remarked that the Aussie dollar was ‘somewhat high’ and that the central bank can cut rates to ‘counterbalance’ the capital inflows. Despite that and the 12-month rate forecast hanging dangerously low, AUD/USD held 1.0250.

New Zealand Dollar: Inflation Expectations at Four Year Lows, Rate Cut Risk Rises
We’ve already seen New Zealand’s most important monetary policy member – RBNZ Governor Wheeler – offer up a bearish voice and threaten the kiwi, but bearish conditions seem to have intensified even further this morning. On docket were the first quarter inflation expectations over the coming two-years surveyed by the central bank. The 2.2 percent read is the lowest in 11 years. Dovish evidence is building.