There isn’t much consistency in the price action of the U.S. dollar this morning but the sell-off in stocks and the rise in Treasury yields indicate that investors are positioning for tapering by the Fed before March 2014. A surprise uptick in service sector activity during the U.S. government was shutdown and optimistic comments from more Federal Reserve Presidents has many market participants rushing to position for a more aggressive timetable to reduce asset purchases by the central bank. Last week the Fed’s less pessimistic views on the economy caught the market by surprise and since then stronger than expected data has supported their views. So even if investors don’t believe the economy is ready for a reduction in stimulus, economic data and comments from Fed officials suggest otherwise.
In the month of October, when the dysfunction in Washington paralyzed the government, many economists believed that growth took a big hit but based upon both the ISM non-manufacturing and manufacturing reports, the government shutdown had virtually no impact on the economy. Both the service and manufacturing sectors gained momentum and the data would have been stronger if U.S. debt troubles did not hang over the markets throughout October. The ISM non-manufacturing index rose from 54.4 to 55.2 last month and more importantly, the employment component of report surged from 52.7 to 56.2. The U.S. is a service based economy and the uptick in the employment subcomponent leads us to believe that non-farm payrolls could surprise to the upside on Friday. Good data is the key to keeping the dollar bid but the currency is struggling to rise consistently because investors remain skeptical and are overweighting relative fundamentals. It is for this reason that sterling is performing so well this morning because U.K. data also surprised to the upside.
Nonetheless, the consistency of comments from Federal Reserve Presidents should not be ignored. Now that the quiet period before the FOMC meeting has ended, policymakers are out in force sharing their views on the economy and monetary policy. Their comments are moving the dollar because investors are still trying to wrap their heads around the Fed’s less pessimistic outlook. Most of the Federal Reserve Presidents that we have heard from are not very dovish including FOMC voter Rosengren who is generally one of the most dovish members of the central bank. He sees the U.S. achieving 3% growth fairly soon which is optimistic and given the expected upturn, he also warned about the costs of QE. With one more dove in the central bank biting the dust, more investors are buying dollars on the view that the Fed could taper before March 2014.
Unless ECB President Draghi downplays the need for easier monetary policy on Thursday, we expect any recovery in the EUR/USD to be limited to 1.3650 and are looking for the currency pair to break below 1.3350. USD/JPY on the other hand is likely to extend higher with a possible break of 99 in the near term. With 10 year Treasury yields up 5bp this morning, it is time for the currency pair to catch up.