[AndrewWoo]

The USD has found a bit of life early this week, after getting completely decimated last week on fears of an eventual downgrade to its AAA credit rating. A lot of the press today and over the weekend was devoted to the USD and its outlook. This morning’s FT discussed how China stuck in a “dollar trap”, since given the size of its USD-denominated reserves it has no choice but to keep buying US assets. An
anonymous official said that the Chinese FX administration has not fundamentally changed its strategy of allocating the bulk of its reserves to US securities (although it has shifted towards buying shorter-term securities), but that it is “very
negative” on sterling, while it is neutral on the euro and bullish on the Australian dollar.

One of the most interesting aspects of last week’s USD selloff was that it came at the same time as flat/weaker equities and increasing volatility, as the dip in the VIX below 30 was short-lived, and it bounced back above 32 late last week. USD’s
relationship with risk aversion was at risk itself, and it looks like the breakdown could finally be materializing. This is a development that traders will be watching
closely, since that means that weak US economic data no longer automatically leads to USD buying.

Over the weekend we heard from a couple of FOMC members, who also seemed to be concerned about the US fiscal situation, and specifically how it relates to the Fed. Vice Chairman Kohn that the central bank needs insulation from political pressure, and that point was repeated by Dallas Fed President Fisher, who was interviewed by the Wall Street Journal. Fisher said “I think the trick here is to assist the functioning of the private markets without signalling in any way, shape or form that the Federal Reserve will be party to monetizing fiscal largess, deficits or the stimulus program.” He also mentioned that during his recent trip to Asia, he was “grilled” by senior Chinese government officials on whether or not the Fed was going to monetize the massive budget deficits.

Today is an extremely quiet day with both the US and UK on holiday, but later this week the focus will probably back on the USD, with a large amount of Treasury supply, starting tomorrow. If any of this week’s three note auctions go poorly, we could certainly see another leg of USD selling.

Other things to watch for this week will be the Japanese trade and industrial production data for April, which will tell us if the improvements in March were just a blip or if the BoJ and Japanese government are correct in sounding more optimistic, and the US housing and durable goods data for April.