Dollar Rally – What the Skeptics are Saying

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Daily FX Market Roundup 05-15-13

Dollar Rally – What the Skeptics are Saying
EUR Extends Losses as GDP Data Confirms Recession
USD/JPY Rally Hinges on Japanese Data
GBP – BoE Upgrades GDP Forecasts, Cuts Inflation Forecast
CAD Rebounds, Shrugging Off Weaker Data
AUD Hit by Falling Gold Prices
NZD – Business PMI on Tap

Dollar Rally – What the Skeptics are Saying

We have made it clear that we like the U.S. dollar and think USD/JPY is headed for a break of 103 and the EUR/USD down to 1.28. However there are many skeptics out there who argue that the dollar doesn’t deserve its current valuation, let alone further gains. Their reasoning has some merits and eventually we believe that the dollar rally will lose momentum but if there’s one thing we have learned about the FX market, it is that currency moves can become more exaggerated and out of line with fundamentals than most people would anticipate. When the optimism reaches a peak, that’s when the moves will reverse and when that occurs the correction can be brutal.

There are a few arguments floating around about why the dollar rally will not last. Some people believe that the Federal Reserve isn’t in a rush to taper asset purchases and when they finally decide to do so it will not mean that they are headed for the exit. At the last central bank meeting, the Fed indicated that they are open to increasing or reducing stimulus based upon incoming data so what they may opt to do is slow asset purchases modestly, take a long break to see how the economy responds and then recalibrate as necessary. While this is probably an accurate assessment of what the Fed will choose to do, if it comes at a time when the Eurozone is still in recession and the ECB is talking about increasing stimulus, it will still be positive for the dollar. Other skeptics argue that the further the dollar appreciates, the more of a headache it provides for the U.S. economy. They are also absolutely right as a stronger currency presents headwinds for the export sector but the U.S. is not a trade dependent economy and can therefore handle a stronger currency better than other countries. The more direct implication of a strong currency is on inflation. A stronger dollar lowers price pressures, which would give the Fed the flexibility to delay changes in monetary policy until they feel that the economy is ready.

Today’s disappointing economic reports are some of reasons why the Fed may want to wait. This morning we learned from the industrial production and Empire State survey that manufacturing conditions deteriorated in April and May. Inflationary pressures also eased according to PPI and foreigners bought significantly fewer dollars in March according to the Treasury’s International Capital Flow report. These reports serve as a reality check for investors who may have grown overly excited about the outlook for the U.S. economy. It also raises some concerns about the sustainability of the improvements seen in April but it is far too early to tell if this slowdown is broadly based because the Empire State survey was the only piece of data for the month May. Tomorrow’s housing starts, building permits, jobless claims and Philadelphia Fed survey will provide us with a deeper look at how the economy has been performing. While the arguments of skeptic have some merit,f or the most part, we still believe that the relative outperformance of the U.S. economy will keep the dollar bid.

EUR Extends Losses as GDP Data Confirms Recession

The EUR/USD dropped to its lowest level in more than a month on the back of disappointing GDP numbers. The Eurozone economy contracted for the sixth consecutive quarter with Germany seeing only 0.1% growth in the first 3 months of the year while France contracted by 0.2%. This left Eurozone growth at minus 0.2% for the first quarter translating to a year over year contraction of 1%. In other words, the Eurozone is still in recession and for this reason alone, the EUR/USD deserves its current valuation. Continued weakness in the Eurozone will only make the European Central Bank more inclined to increase stimulus or at least become more vocal about the possibility. As our colleague Boris Schlossberg pointed out, “the ECB’s passivity in the face of the draconian cuts in fiscal spending has resulted in an economic quagmire with growth in the region at standstill as deflation takes hold. If the recent BOJ experiment in highly accommodative monetary policy boosts Japanese economic growth, the pressure on European policymakers to ease further will accelerate.” In the coming days, we expect ECB policymakers to remind the market that negative deposit rates or purchases of asset-backed securities are on the table and when they do, the EUR/USD could extend its losses. It is also worth mentioning that EUR/CHF rose to it highest since the Swiss National Bank put a floor under the currency pair in 2011. However the currency pair failed to hold onto its gains even after shrugging off a surprise increase in producer prices.

USD/JPY Rally Hinges on Japanese Data

USD/JPY held onto its gains even after a series disappointing U.S. economic data. Overnight the currency pair climbed to a fresh 4.5 year high but the currency pair pulled back after U.S. data. Looking ahead, the sustainability of the USD/JPY rally will largely hinge on tonight’s Japanese economic reports. First quarter GDP numbers are scheduled for release from Japan along with the Ministry of Finance’s weekly flow of funds data. Last Thursday’s report showed Japanese investors buying foreign bonds for the first time in 6 weeks and the Japanese need to continue to buy foreign bonds in order for the USD/JPY rally to continue. We think the data will show consistent demand but if the Japanese return to net sales, then USD/JPY could pull back and give up some of its recent gains. As for growth, a number of Japanese economic reports confirm that the economy has returned to growth in the first quarter but there’s still room for a downside surprise because the trade deficit widened in Q1. Given the recent extension in USD/JPY, a correction would not be unusual and weaker Japanese economic reports could be the perfect catalyst since tonight’s releases hold particular importance.

GBP – BoE Upgrades GDP Forecasts, Cuts Inflation Forecast

Compared to many of the other major currencies, the British pound has held up well against the U.S. dollar and even managed to tack on gains against the EUR. U.K. economic data continued to beat expectations with jobless claims falling 7.3k in the month of April compared to a forecasted decline of 3k. Average weekly wage growth slowed but any negative sentiment was offset by the Bank of England’s higher GDP and lower inflation forecasts. This is the best of both worlds for the central bank because lower inflationary pressures allow them to keep monetary policy accommodative to support growth. This is the first time since the Financial Crisis that the BoE upgraded their growth forecasts. They now expect 2013 growth to hit 1.2%, up from their prior forecast of 0.9%. However a large part of this upgrade was due to stronger growth in the first half of the year as the BoE cut their second half forecasts. In terms of inflation, the central bank now believes that consumer prices will drop to their 2% target in the third quarter of 2015 over the first quarter of 2016. This is the last Quarterly Inflation Report signed off by Bank of England Governor Mervyn King. When Mark Carney takes office in June, he may take a different approach and opt for easier monetary policy since he’s been tasked with jumpstarting the economy.

CAD Rebounds, Shrugging Off Weaker Data

The Canadian and New Zealand dollars rebounded against the greenback today while the Australian dollar extended its losses. The pullback in the greenback helped the pairs recover amidst the lack of market moving economic data. The Canadian dollar shrugged off the surprise 0.3% decline in manufacturing sales and smaller 0.6% increase in existing home sales. The Australian dollar also ignored slower wage cost growth and a decline in new motor vehicle sales but fell victim to the 2% slide in gold prices. Considering the lack of a specific catalyst outside of weaker U.S. data, we see today’s recovery in commodity currencies as noting more than a relief rally. Looking ahead, we have New Zealand’s Business PMI index and Canadian International Securities transactions scheduled for release. Given the deterioration in the Australian and Chinese economy and the drop in commodity prices, we expect New Zealand to report weaker business activity. For the most part, tomorrow’s economic releases from New Zealand and Canada should only have a limited impact on their currencies – risk appetite and the market’s demand for dollars will continue to be the driving force behind currency flows.

Kathy Lien
Managing Director

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