The U.S. dollar is struggling to hold onto its gains after a round of disappointing economic data. Manufacturing conditions deteriorated in April and May according to the industrial production and Empire State manufacturing reports. Inflationary pressures 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 because the Empire State survey was the only piece of data for May.

Yet the decline in the Empire survey was indeed concerning. Given improvements in other parts of the economy, analysts were looking for a small uptick in manufacturing activity in the NY region. Unfortunately the index dropped from 3.05 to minus 1.43 in the month of May. The details of the report showed new orders and shipments turning negative while inventories and unfilled orders contracted more steeply. This reflects deterioration in sales growth and inventory growth, which implies stagnation and weakness in manufacturing. Concerns about the sector were exacerbated by last month’s 0.5% drop in industrial production. Producer prices also fell -0.7% last month compared to -0.6% in March. Softer inflationary pressures will allow the Federal Reserve to keep monetary policy accommodative if they start to become worried. According to the TIC data, foreigners bought only $2.1B worth of U.S. assets in March and were actually net sellers of U.S. Treasuries for the second month in a row.

While these reports caused an intraday pullback in the dollar, the greenback is still fighting to hold onto its gains because investors feel that today’s U.S. economic reports will not have a major impact on how the Federal Reserve feels about tapering asset purchases. The Fed’s focus is on jobs and based on recent jobless claims, there have been further improvements in the labor market. As long as the next non-farm payrolls report does not drop suddenly, we still expect the central bank to vary asset purchases before the end of the year. In other words, the dollar rally is still the real deal because the Fed and the ECB, BoJ and RBA are in very different positions – the Fed is thinking about reducing stimulus at a time when the rest are leaning towards increasing support for their economies.

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. Continued weakness in the Eurozone economy will only make the ECB more inclined to increase stimulus or at least become more vocal about this possibility. If the ECB reminds the market that negative deposit rates or purchases of ABS are on the table and we expect them to do so, the EUR/USD could extend its losses.

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