The U.S. dollar is trading higher against most of the major currencies this morning but the ugly intraday reversal candle in USD/JPY indicates the momentum is waning. Earlier gains this week in the greenback was supported by positive economic data, spike in Treasury yields, the House’s approval of the budget deal and nomination of Stanley Fischer as vice chairman of the Federal Reserve but today, the drop in producer prices reminds investors why the central bank will look to unwind stimulus slowly. In the U.S. and many other parts of the world, inflation is nonexistent and this provides central bankers will the flexibility to keep monetary policy very easy.

However even with the 0.1% decline in PPI in November, the year over year rate increased to its highest level in 3 months. This does not mean that inflation will be a motivation for earlier tapering but it won’t stop the Federal Reserve from reducing asset purchases this month. Profit taking may have driven USD/JPY off its highs but our positive outlook for the greenback has not changed. Janet Yellen should be confirmed as the new Federal Reserve Chair in the coming week and with Stanley Fischer at her side, the central bank will have more balanced leadership. Fischer is generally known as a hawk that does not support forward guidance. While it can argued that he could stand the way of changes that she wants to make, we view the opposing views as complimentary as it would provide a more balanced conversation. If the Federal Reserve does not taper in December, we can assume that Fischer will support early and more aggressive tapering in 2014. The rally in the dollar this week was driven largely by the rise in U.S. yields and today, the dip is weighing on the greenback.

Meanwhile a large LTRO repayment to the European Central Bank is shielding the euro from further losses. Banks will return EUR22.6 billion next week, 3 times more than usual and the largest amount since the second repayments of 3 year loans began in February. The distortion is most likely caused by the cancellation of the next 2 repayment dates – the next opportunity to repay the loans will be on January 10. Repayment of these loans reduces the liquidity in the financial system and puts upward pressure on rates, something the dovish ECB won’t be happy to see especially since banks failed to funnel the loans into the real economy.

The Australian dollar appears to have stabilized below 90 cents but we believe that this consolidation will be temporary. The continuation of existing trends in the FX market hinges on next week’s FOMC meeting and the decision to taper will be a close one.

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