USD recovers on hawkish comments from Fed's Plosser and renewed equity rally. Key RBNZ rate decision on tap.

USD rallies through first important resistance levels - will there be any follow through?

MAJOR HEADLINES – PREVIOUS SESSION

• US May House Price Index fell -0.3% MoM vs. -0.8% expected
• US Weekly ABC Consumer Confidence was steady at -41 vs. drop to -42 expected
• Australia Jul. DEWR Skilled Vacancies out at -0.5% vs. -0.5% in Jun
• Australia Q2 Consumer Prices out at 1.5% vs. 1.3% expected

THEMES TO WATCH – UPCOMING SESSION
Key Risk Events (All times in GMT)

• UK BOE Minutes (0830)
• UK Jun. BBA Loans for House Purchase (0830)
• EuroZone May Industrial New Orders (0900)
• UK Jul. CBI Quarterly Industrial Trends (1000)
• Canada Jun. Consumer Price Index (1100)
• US Fed's Mishkin to speak (1300)
• US Weekly Crude Oil and Product Inventories (1435)
• US Fed's Kohn to speak (1515)
• US Fed's Beige Book (1800)
• New Zealand RBNZ Rate Decision (2100)
• Japan Jun. Merchandise Trade Balance (2350)

Market Comments

Yesterday, we saw EURUSD teasing the market a bit by breaking short-term resistance levels, only to see the pair swoon later in the day on comments from the Fed's Plosser that almost seemed designed to specifically jump-start the greenback by rejecting some of the market's complacent assumptions. Mr. Plosser is a voting member of the FOMC and a known hawk, as he voted against two of the rate cut decisions this year. Besides stating that the Fed should hike rates again "sooner rather than later", another important comment (especially if it were true!) was that the US presidential election cycle would not weigh on Fed decisions. Mr. Plosser also claimed that the Fed's role in the GSE (Fannie Mae and Freddie Mac) situation is "limited" and that he was concerned about the moral hazard involved in this issue. The risk with reacting to comments from this source is that Mr. Plosser is a known hawk in a divided Fed, so we need some follow up from the chairman to give the idea of imminent Fed tightening credibility - though we did see the entire US yield curve rising yesterday, especially at the front end.

Treasury Secretary Paulson was also out trying to position his Fannie and Freddie rescue plan (very rightly so) as important not only for the US housing market, but also for US and global financial markets. The plan, together with additional provisions added in by legislators, will be voted on today and may pass both houses and become law. The Congressional Budget Office claims that the plan would only cost taxpayers $25 billion. (Yeah right. We suspect that this could turn out to be a modest down payment...but the US government cannot politically afford to let these institutions fail and is unwilling to risk the stability of the USD and trust of foreign investors who hold endless billions of GSE-related and US agency debt.

Supporting roles in the USD recovery yesterday went to a strong rally in US equity indices and another steep drop in the oil price, which traded below 128 dollars a barrel since early June. US banking stocks had another banner day, rising over 10% from open to close. This all looks well and good for the USD right now, as we ponder whether the USD strength will follow through in coming days. But longer term, we continue to harbor the belief that recent equity rally is a short-covering rally triggered by an overpositioned market and awkward new short selling rules from the powers that be that have worked like a little kid viciously kicking an ant mound and watching all the ants scurrying for cover.

Eventually, we see a return to the rather stark story of a worldwide growth slowdown, which has little to do with spastic moves in banking stocks, the only thing that the market seems to care about in recent days. For a more sustainable USD recovery story, we also need to see the USD strengthen as the market grows more pessimistic about growth prospects around the world as the old "recoupling" story returns to the fore. Perhaps after this week's fat tail rally in banking stocks (one market observer claimed that last Tuesday's banking stock rally was a 11-standard deviation event - and this was followed up just yesterday by a move that was even larger from open to close!) and passage of the GSE legislation, this story will begin hold less sway over the FX market in coming days and weeks. Another interesting note about the USD recovery yesterday was seen in the USD/Eastern Europe crosses, which have been a popular place to express USD weakness of late. These rallied sharply for the first time in months, with USDCZK up over 3% on the day.

The RBNZ is out tonight with its rate decision, with the market about evenly divided on whether the bank goes forward with a 25 bp cut. Is the short NZD trade a crowded one or is there further room for it to fall? In the longer term, we believe the latter is true, but having a look at the AUDNZD chart is enough to make us a bit nervous about jumping in at these levels. If the RBNZ don't cut, a short squeeze could be in the cards in some crosses.

Charts:
USDCAD
USDCAD moves into our crosshairs again after yesterday's poor Canadian Retail Sales showing and drop in oil and gas prices and as the pair saw a reasonably strong reversal yet again from the support at parity, which also coincides with the 200-day moving average. We now focus on a move higher through the 55-day MA as a further sign that the recovery may be on. The latest developments in the interest rate differentials are supportive of a move higher as well. Beware today's Canada CPI and the US weekly oil inventory figures, however.

USDJPY
We can't help but point out that the resistance the market has been obsessing over for the last many weeks in USDJPY at the 200-day moving average finally gave way yesterday. The obvious next focus would be the June high at 108.58.