Bernanke testimony: through the looking glass

The dollar has fallen today on market
perception of a less hawkish testimony by Fed Chairman Bernanke this morning.

The questions on everyone’s mind are: When will the Fed be done? When will the
peak in Fed funds rate that justifies several months of extreme dollar
bearishness finally arrive?

To an extent, the new chairman himself is wondering about the same. In his
testimony, he points to reduction of slack in resource utilization, slowdown in
housing, narrowing in economic growth, and even the prospects of a slowdown in
inflationary pressure in 2007. He also suggests that there are rate hikes in the
pipeline of 17 consecutive tightenings that have yet to make an impact on the
economy. In short, the dovish perception and dollar bearish response is
certainly justified. Justified… but is it correct?

In his short history as Fed chairman, Bernanke has come to odds with the
market’s reaction to his Congressional testimony once before. Recall early May
of this year when the interpretation of a near-term pause in Fed tightening
proved to be as premature as it was misguided. Everyone got a little egg on
their face: investors for reading too closely into Ben’s comments, a certain
CNBC anchor who leaked the revelations that the “markets got it wrong”, and the
Chairman himself for his inability to recognize the market sensitivity to his
every word. Since then, Bernanke proved to have learned a valuable lesson,
keeping a tight lid on the immediate monetary policy actions. Whether this
lesson was learned by the speculators remains to be seen in whether the dollar
bears can hold on to their gains — we remain skeptical for several reasons.

For one, today’s testimony underscored inflation as the primary factor for
future policy. Even when scolded about the negative effect of excessive
tightening during Q&A by an overzealous senator who pointed to the “401K losses
of average Americans”, Bernanke suggested that price stability is essential to
growth and the consequences as measured by the stock market if FOMC kept
interest rates in the 4.5-5.0% range were as perilous. Considering today’s 0.3%
reading in core CPI and elevated by the protracted Middle East conflict oil
prices, which the Chairman paints as one of the culprits for rising inflation,
an immediate pause is therefore not very likely.

Two, the extreme dollar bearishness being built up among the big players runs
the risk of the “depletion of ammo”. Although counterintuitive at first, it is
hardly surprising that the peak of Fed funds rates has historically coincided
with dollar rallies, as bearish positioning ahead of the end of tightening
implied profit taking after the last hike. As dollar bearishness soars to record
highs, the profit taking potential surges as well.

Technically, dollar rebound remains justified as well. Consider the most popular
anti-dollar choice — EURUSD. After breaching a multi-month trendline support at
1.26, the pair has successfully broke below 1.2480 lows. As long as the initial
trendline is preserved, renewed selling remains likely. Furthermore, a lower
high and a failed retest of 1.30 also places the bullish momentum into question.

Our preferred trading strategy avoids the volatility vis-à-vis
FOMC expectations with a long AUD/CHF, or a synthetic combination of long AUD/USD
and USD/CHF positions. Fundamentally, AUD continues to benefit from rising
commodities and a hawkish central bank. Technically, the double-top to
double-bottom transition of the multiweek resistance turned support level at
0.9320 confirms the validity of the breakout. Finally, the vast interest rate
advantage of AUD to CHF is compelling for a medium-term trade in itself.

Black is the fund manager at Black Flag Capital Partners and Chairman of
the firm’s Investment Committee, which oversees research, investment and
trading strategies. You can find out more about Jes at
to organizing the hedge fund he was hired by MG Financial Group to help
run their flagship news and analysis department, After four
years as a senior currency strategist he went on to found – a research firm catering to professional traders.