The Fed’s Dollar Problem

Daily FX Market Roundup 10.26.15

A strong dollar can be a major problem for the Federal Reserve in a low growth, low inflation environment – which unfortunately describes current economic conditions. Even before the ECB signaled plans to ease and the PBoC cut interest rates, Fed districts expressed concerns about the strong dollar’s impact on manufacturing and tourism activity. The pressure on the U.S. economy increased in the past week with the dollar climbing to its highest level versus the euro and Japanese Yen in 2 months. Many major U.S. corporations blamed their lost revenue on the greenback’s rise and it is likely that millions of dollars in revenue was stripped away by the currency’s latest gains. According to Bloomberg, two out of three companies in the S&P 500 that reported earnings through October 22nd mentioned the strong dollar or currency related woes in their conference calls including big names such as Delta, Johnson & Johnson and Coca-Cola. The Fed estimates that a 10% rise in the dollar has a small initial but significant residual impact on growth. So the U.S. economy will be feeling the drag of the dollar’s 14% rise over the past year for some time. Approximately 4% of those gains were incurred in the last 2 months but further strength is likely towards the end of the year as the Fed moves closer to tightening and the ECB to easing.

The Federal Reserve does not want a stronger dollar. If they were prepared to raise interest rates to slow a booming economy, dollar strength is unavoidable and in fact manageable because inflation would be higher and growth firm. However U.S. CPI is at zero, oil prices are slipping towards $40 a barrel and the misses in earnings along with slower job growth tells us that the economy is far from booming. Add China and Europe’s problems to the mix and the Fed has very little reason to talk up the dollar this week. Instead the arguments for a 2015 rate hike are fading and in order to manage expectations appropriately the central bank be more elusive which would help to pare the dollar’s gains and give the U.S. economy some reprieve. More specifically while we are long term dollar bulls, the “trader” in us sees a greater chance of dollar weakness going into and after this week’s FOMC meeting. Today’s sharp 11.5% drop in new home sales, which was the largest decline since July 2013 is a reminder of the vulnerabilities in the U.S. economy. A number of second tier U.S. economic reports are scheduled for release tomorrow including durable goods, consumer confidence, S&P CaseShiller House Price Index and Markit PMIs.

The euro rebounded against the U.S. dollar today following softer U.S. data. In the early European session, we learned that German business confidence increased in the month of October but that along with Friday’s stronger Eurozone PMI report failed to lend support to the currency. The ECB sealed EUR/USD’s fate when they signaled plans to ease and now we view any rally in the currency pair as a dead cat bounce that should be sold. German businesses may be hopeful that economic conditions will improve in the next few months but currently they see economic activity as weak. Ideally we would like to sell EUR/USD between 1.1145-1.1245 and hope that the currency pair will trade up to that level on FOMC.

Sterling also rebounded against the greenback and is in play over the next 24 hours. Third quarter GDP numbers are scheduled for release and while economists are looking for slightly weaker GDP growth, the sharp rise in retail sales puts the risk to the upside. If GDP growth exceeds 0.7%, we could see GBP/USD break through the 50-day SMA near 1.5400. The currency pair tested but failed to close above this level but a strong number would open the upside.

The New Zealand dollar continues to be one of the best performing currencies and the higher NZD rises, the more attractive the short trade becomes. NZD could be rising ahead of tonight’s trade balance report, which should be better given the recent uptick in dairy prices. However the RBNZ won’t be happy with the recent moves in the currency. In the past month, NZD/USD has risen from a low of 0.6250 to 69 cents while AUD/NZD has fallen from a high of 1.1350 to a low of 1.0575. The stimulus from China helps ease some of the RBNZ’s concerns but we would be surprised if they did not mention the recent appreciation of the currency. The Australian dollar moved up despite the lack of economic data and lower copper prices. The Canadian dollar on the other hand is surprisingly resilient given that oil prices have fallen to a 6-week low.

Meanwhile the odds of BoJ easing declined after Prime Minister Abe Adviser Hamada dismissed the need for easing. However Japanese economic reports have taken a turn for the worse since the last central bank meeting and we can’t help but remember that a year ago, the BoJ sent USD/JPY soaring 500 pips in 3 days after they shocked the market with more QE.

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