What to Expect from the U.S. dollar in Q3

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The third quarter has officially begun and the sweltering heat indicates that we are well into summer. Thanks to the long hours and hard efforts of European leaders last week, investors will finally be able to relax and enjoy their shorter workweeks and vacations. By announcing a banking union that was clearly enough to satisfy the low expectations of investors, EU leaders effectively neutralized the near term risks in the market. Volatility came crashing down as equities and currencies soared across the globe. Most importantly Spanish and Italian 10 year bond yields dropped back to manageable levels with yields in Spain moving far away from the 7 percent danger zone.

On Friday, we outlined all the reasons why the EU announcements have not ended Europe’s sovereign debt crisis but as Traders First and Analysts Second, we have to respect the price action. Sentiment shifted with the plans for a banking union under the watch of the ECB and this could be enough to keep European yields low for the next two months. This means we should be moving into a period of summer consolidation or range trading for the U.S. dollar.

While there is still the possibility of some monetary policy changes from central banks, the EU Summit decisions eased the tension in the financial markets and eliminated the need for emergency support. Countries around the world have extremely accommodative monetary policies already and in this environment any additional stimulus has and will continue to have a decreasingly significant effect on their economy and currencies. For this reason, it may be smarter for central banks to reserve their tools for a time when their economies really need it and when it will have a more significant psychological impact on the financial markets. Three central banks have monetary policy announcements this week and most likely all of them will keep policy unchanged. Even if the Bank of England increases asset purchases, we do not expect a significant increase in volatility.

Summer of Consolidation

As long as European bond yields remain low, there is no immediate risk for the euro and in turn the financial markets. Of course there are plenty of long term risks that could lead to renewed demand for the dollar – the European Stability Mechanism was given a bigger mandate without more money and Europe received no true commitment to burden sharing. Most of the decisions provided only short-term solutions and the widely touted growth package uses existing funds rather than new money, which equates to no meaningful stimulus and potential underperformance of the Eurozone economy. Nonetheless the enthusiasm from last Friday’s EU Summit should provide the market with support for the rest of the summer and with most central banks expected to remain on hold, there is very little catalyst for volatility over the next 2 months. The next EU Summit won’t be until October. The only thing that reverse the gains in the euro, send investors back into the arms of the U.S. dollar and sap the market’s optimism would be weak economic data. However after last week’s good news, investors will need to see a few months of overwhelmingly soft data to start pricing in immediate stimulus from the ECB or the Federal Reserve which is when uncertainty and hence volatility could return.

In other words, we believe that we have seen a near term top in the U.S. dollar. BUT this does not mean that the dollar rally is over or that the EUR/USD will not revisit 1.25 over the next 2 months. What it does mean however is that we do not expect a fresh wave of dollar strength during the summer or first 2 months of Q3. More specifically, we are looking for the EUR/USD to trade between 1.25 and 1.30 and USD/JPY between 78 and 82 from now until Labor Day on September 3rd. After which we expect volatility to return in the final month of the third quarter as investors try to figure out what EU Leaders will do and say at their October Summit.

Kathy Lien
Managing Director

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