FX - Dollar Recovers from Flash Surge in Investor Sentiment following China’s Dropping its Fixed Regime

• British Pound: What are the Scenarios for Tuesday’s Budget Report?
• Euro’s Take on Unpegged Yuan Mixed, ECB Increases Government Bond Purchases
• Canadian Dollar Tumbles after BoC’s Warnings, Traders Look Ahead to CPI Numbers
• Japanese Yen Split between Sentiment and Fundamental Implications of China’s Step towards a Float

Dollar Recovers from Flash Surge in Investor Sentiment following China’s Dropping its Fixed Regime
It was a busy day for the risk-sensitive capital markets Monday; and that would naturally translate into a heightened level of activity for the US dollar as well. Given the light economic calendar and the focus of the financial headlines for the opening session of the week, it wasn’t difficult to discern that the China’s announcement that it was dropping its peg for the yuan (again) was the topic du jour. What does this really mean for market-wide investor sentiment and the dollar itself? Not as much as would be expected from today’s price action. First, we need to establish what has actually changed with this shift in policy regime. The People’s Bank of China announced two days ago that it would no longer aim to hold an absolute peg for the Chinese currency (the yuan) against the US dollar. On the other hand, the policy authority said that there was no reason to allow for “large scale” moves and that this effort was aimed at increasing its “flexibility” while simultaneously preventing “excessive” volatility. Upon the open of regular trading in the Asian session, this move triggered a swell in investor optimism. The basis for this connection between risk appetite and exchange rate policy can be traced back to the notion that such a liberal effort on China’s part speaks to their own perception of health for the domestic economy and market (one of the world’s top performers on both accounts). Furthermore, this shift can be taken to mean the imbalance in the world’s recovery will be leveled off and therefore find a greater level of stability. Reflecting this confidence, the S&P 500 rallied as much as 1.2 percent through the opening of exchange trade while the yield intensive AUDUSD climbed 1.6 percent.

Yet, as it so often happens, skepticism would eventually leak into the market and the surge in optimism through the morning was almost completely retraced by the end of US trading hours. A rational review of this change in policy leaves gives us a better assessment of its scope. The shift to a managed float (whereby the PBoC maintains on a daily basis) is not a new one. A similar effort was made between 2005 and 2008 whereby the yuan appreciated 21 percent against the US dollar. This policy effort did not dramatically alter trade imbalances or radically alter investment initiatives (due to the preservation of regulations preventing capital outflows and inflows by China). It is noteworthy that the dollar did depreciate markedly through this period; but that is more a reflection of the effort to find an alternative reserve currency and the imbalance of yield interests rather than a simple reflection of the weight yuan interest would have on the benchmark dollar. For sentiment this time around, China’s efforts do not necessarily confirm its strength. The nation is still clearly exposed to excessive credit build up over the years and the effort to withdrawal stimulus will soon bear these strains. And, as for this China rebalancing the global market and thereby fortifying the worldwide recovery; if a three-year period of a managed float could provoke such a change, the very beginning of a new phase will do very little.

With the reversal in investor optimism, the Dollar Index would turn a steep loss into a 0.3 percent advance for the day. Whether or not this momentum is extended into tomorrow will partly be the responsibility of echoes and reinterpretations of the Chinese news; but more likely, new exogenous headlines and predicable scheduled event risk will have a greater sway on price action. The UK’s budget report could provoke a sympathy move from the US as both economies are frequently listed as the top nations at risk of losing their sovereign credit ratings over the long-term. As for the docket, the existing home sales data for May and house price index for April will be sought to offer a sound reading for the sector after months of volatile changes. Also of interest is Treasury Secretary Geithner’s testimony before the TARP Oversight Committee.

Related: Discuss the US Dollar in the DailyFX Forum, Weekly Spotlight: China Unleashes the Yuan

British Pound: What are the Scenarios for Tuesday’s Budget Report?
The first 24 hours of trading this week were defined on a relatively light economic calendar. Looking over the coming 24 hours, that docket fills out with meaningful market movers; but once again, the top event is most likely to be another exogenous announcement. This time around, currency traders will focus on the publication of the UK government’s budget. Considering the ratings agencies (most recently Fitch) have warned that Europe’s second largest economy is at risk of losing its top credit score should more not be done to reign in its finances; this event could very well have market-wide implications. However, for the biggest response, we look directly to the British pound. It is true that preventing any speculation that the UK is at risk of a downgrade is imperative to its strength; but at the same time, budget cuts are inherently a detriment to economic activity. Whether this proves a bullish or bearish event for the sterling depends on the balance the financial plan finds between seeking fiscal responsibility and fostering a still feeble economic recovery. More precisely, the reaction to this event depends upon how the market interprets the outcome. Should the cuts be construed as excessive, the pound will almost certainly plunge for fear of a double dip recession. If too little is done (unlikely) the currency will still decline. Only a happy balance will trigger and sustain a fundamental rally for the currency.

Euro’s Take on Unpegged Yuan Mixed, ECB Increases Government Bond Purchases
News that China was loosening its peg against the US dollar would initially benefit the euro as the shared currency is the greenback’s primary counterpart. However, the effort to diversify away from this acknowledged reserve is admittedly modest at this point and the economic benefit the move would construe is minor considering the yuan has already appreciated approximately 15 percent against the euro so far this year. More meaningful was news that Greece’s state budget between January and May dropped 38.7 percent from a year before to 8.9 billion euros. Offsetting this positive turn, the ECB reported another 4 billion euros of government bond purchases last year, blurring the guise of improvement.

Canadian Dollar Tumbles after BoC’s Warnings, Traders Look Ahead to CPI Numbers
For a central bank that is supposedly supporting a strong economic recovery and a hawkish rate regime, the BoC certainly sounded dovish Monday. Comments from the authority reflected global fiscal strains potentially hurting Canada’s interbank market and the risks of another severe financial stressor on the markets were high. If May CPI cools as expected tomorrow, the loonie will quickly come under pressure.

Japanese Yen Split between Sentiment and Fundamental Implications of China’s Step towards a Float
The loud and constant drone of protectionist claims between the US and China help to better paint the benefits of a freer exchange system on the US. For the yen, on the other hand, the impact is debatable. The implications through risk appetite channels are blatant and overwhelming; but from an economic standpoint, this move could leverage Chinese purchasing power of Japanese goods over the long term.

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

DailyFX provides forex news on the economic reports and political events that influence the currency market.
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