Could Bernanke be Dollar Negative?

The US dollar has recovered nicely from the sell-off that culminated in the immediate aftermath of the disappointing jobs data at the start of the month. These gains were scored despite the movement of interest rate differentials against the US. The fact that the premium the US offers over the euro-zone has narrowed also means that US debt instruments have outperformed Europe’s. There could be a number of possible reasons why US debt instruments are out-performing. However, given that the market continues to lean toward a Fed hike at the August 8 FOMC meeting, it is not because of a dovish outlook for US monetary policy. Rather, given the larger environment, US debt instruments appear to be benefiting from safe haven flows as capital reacts to the geo-political tensions and equity market slides. The emerging market equities looked to have stabilized since the middle of June but have turned down again.

After dropping 27% from May 10 through June 13, the MSCI Emerging Market Index (EEM) rose 18% into early July but has since fallen 7.5% and looks set to fall further. Similarly, emerging market bonds trade as spreads against US Treasuries. As the emerging market bonds are liquidated, the Treasuries sold against them are bought back.

With the Bank of Japan rate hike behind us, the next important focus is Federal Reserve Chairman Bernanke’s semiannual testimony before the US Congress. The market still leans albeit slightly toward an FOMC will rate hike rat the August 8 meeting. The risk is that Bernanke sticks to his guns and stresses that the Fed is data dependent. In the current context, this is likely to be interpreted as dovish by many market participants. As Bernanke reviews the recent string of data, he will, as he has already done, point to the moderation of economic activity and that some market based measures of inflation expectations have also eased recently.

One complication to this scenario is that the June consumer price index is scheduled for release a couple of hours before Bernanke’s testimony. On one hand, as long as the core measure is below 0.3%, Bernanke, who probably will have some inkling of the data, will be able to stick to the script outline above. On the other hand, he will not want to give the impression that US monetary policy rests on a single number and a flawed measure at that. It is entirely likely that with the benefit of hindsight, Bernanke’s transition to the helm of the Fed will be regarded as generally smooth and much smoother than say Greenspan’s transition in 1987. What seems to be more of an issue that Bernanke’s communication style is the fact that this tightening cycle has been unique in the persistence of rate hikes and the clear—even under the strategic ambiguity of Greenspan—guidance. Such guidance is no longer possible, given the conflicting economic signals and objectives. Many investors continue to look for such guidance even though the Fed has made its stance abundantly clear: The trajectory of policy is data dependent.

The August Fed funds futures contract is confined to an 18.5 tick range. For the sake of the argument we have to assume that the Fed will achieve its target Fed funds rate on average over the course of the month. If the Fed pauses in August, fair value for the Aug contract is 94.75. And if the Fed hikes 25 bp (50 is over the top), fair value is 94.565. The contract is currently trading near 94.655, which translates into a 51% chance of a hike. Given the moderation of the economy, price pressures and the wealth impact of the falling stock market and housing market that is rolling over, the risk is that anything but confirmation of an August hike will be seen by market participants, looking for a guidance fix, as dovish.

This in turn could weigh on the US dollar. Initial conditions are important. After selling off hard in late June through early July, the dollar has now retraced a good part of those losses. In fact, at today’s low of $1.2626, the euro has fulfilled the 61.8% retracement objective. Should this area be convincingly broken, there is scope to the late June low near $1.2480. A similar retracement is found in the dollar-Swiss franc rate near CHF1.2400. Today’s high was CHF1.2380. A convincing break of that could signal a move toward CHF1.2520. Support for sterling is seen just in front of $1.8300 and a break could signal another half to full cent decline. What this technical view suggests is that follow through dollar gains early next week may provide a low risk opportunity to sell the greenback. As is its wont, the yen is marching to a different drummer. The yen remains, even after the first rate hike in six years, a cheap source of financing. A dollar advance above JPY116.50-70 could spur a move toward JPY118.00.