Investors continued to buy dollars this morning against European currencies. The euro extended lower for the sixth consecutive trading day while the GBP/USD broke below 1.60 for the first time in 2 weeks. Demand for dollars has been driven by adjustments in expectations for Fed tapering. This morning we heard from 2 Federal Reserve officials both of whom alluded to their desire to taper sooner rather than later. Manufacturing in the U.S. also accelerated in the month of October, creating additional demand for the greenback.
The ISM manufacturing index rose to 56.4 from 56.2 this month. The increase was small but economists had been looking for a decline and the fact that it rose at all caught everyone by surprise. The acceleration in manufacturing activity suggests that the U.S. recovery is not as weak as the market had feared, especially since the index rose to its strongest level since April 2011 and this supports the case for earlier tapering by the central bank.
Fed President Bullard who is a voting member of the FOMC this year said improvements in the labor market could back the case for QE tapering. While he reminded everyone that the decision to taper is data dependent, he also said the labor market has “clearly improved since September 2012” and “the odds of QE taper is expected to rise amid labor market gains.” The key question for the central bank is whether these gains are sustainable and between now and the December FOMC meeting, two nonfarm payroll reports will be released. Bullard is clearly worried about the risk of asset bubbles and inflation which suggests that he could be onboard with tapering this year, especially as he believes that a “small cut in QE would still leave monetary policy very stimulative.” Fed President Plosser may not be a voting member of the FOMC this year but he votes in January and while he thinks there is not much the central bank can do right now, he downplayed the impact of the shutdown on the economy and expressed concerns about inflation down the road. Both policymakers believe that growth will accelerate next year and their optimistic view suggests that they favor earlier tapering. This confirms that the central bank on balance is not as dovish as the market had anticipated.
The dollar also extended its gains against the Japanese Yen but its rise against the commodity currencies were limited by stronger data in Asia. The big action however continues to be the euro, which has now dropped more than 2% this week. If the losses were maintained, it would be the largest weekly decline in the EUR/USD since June 2012. No economic reports were released from the Eurozone this morning but investors continue to price in the possibility of additional stimulus from the ECB. Yesterday ECB Governing Council member Nowotny raised the possibility of another LTRO program after the current one expires and with annualized consumer price growth dropping to its lowest level since November 2009, banks are rushing to adjust their forecasts for the ECB with some now favoring a rate cut this month. This view may appear to be aggressive but it is not inconceivable because the central bank’s number one priority is inflation.