Dollar firm, but beware of a short covering euro bounce

The USD has risen sharply since the end of April, benefiting from the ongoing turmoil in the Eurozone and rise in US Treasury yields (2-year). Markets have managed to brush US fiscal and political concerns under the carpet as focus centres on Europe. The USD also managed to shrug off a soft April retail sales report and a slightly more cautious set of FOMC minutes.

A recovery in April durable goods orders, new homes sales and a relatively stable reading for Michigan confidence should ensure that the USD’s upward trajectory remains unimpeded this week. Given the potential for continued uncertainty ahead of Greek elections in mid June, risk aversion and the USD are set to remain elevated.

In Europe, it’s all about Greece and the machinations ahead of fresh elections in mid June. The EUR shows little sign of stabilising ahead of these elections. Data releases will take a back seat although the calendar will be heavy. FX markets will have one eye on the May German IFO survey and the flash readings in purchasing managers indices. The PMI data will give no relief to the EUR, with the data consistent with growth contraction for the most part while the IFO is set to register a decline too.

Meanwhile, pressure on German Chancellor Merkel to accept measures that were previously vetoed at an informal EU summit on Wednesday has also heightened. Such measures include direct recapitalisation of banks and/or unlimited purchases of peripheral country debt by the ECB and through the Eurozone rescue fund.

Admittedly the large extent of short market positioning (the latest CFTC IMM report revealed an all time low for EUR positioning) means that the risk of a bounce is high in the event of any good news or perhaps in the wake of any renewed securities markets purchases by the ECB or fresh hints of a third LTRO. Whether there will actually be any good news is another question entirely.

USD/JPY has been relatively stable despite a rise in US bond yields compared to Japanese JGB yields, with rising risk aversion helping to keep the JPY firm. The Bank of Japan meeting this week has the potential to change the currency pair’s trajectory but is unlikely to do so. No action is expected at the policy meeting on Wednesday, leaving the JPY with a firm bias.

Trade data will provide some justification for a more bearish stance on the JPY, with another deficit set to be registered in April as export conditions remain weak. However, as usual the JPY will continue to ignore domestic economic data and focus more on relative yields and risk.

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