This Week's Key Dollar Drivers

The most important driver of the dollar remains the de-synchronization of the monetary policy cycle. The early and more aggressive action by the US, and the institutional flexibility, leaves the Federal Reserve in a position to begin normalizing monetary policy several quarters at least, ahead of the eurozone, the UK and Japan. Other countries, including China, Australia, New Zealand, Sweden, and Norway are also in the process of, or are anticipated to be, easing policy as well.

Improvement in the US labor market is key. The strength of the May employment report fortifies conviction that the March weakness was a bit of a fluke, and in any event, not reflective of the underlying trends. The same can be said of the contraction in Q1 GDP. We recognize that the trend growth in the US economy has slowed on this side of the Great Financial Crisis. The two drivers of growth—labor force growth and productivity—have slowed. This means that even at 2% growth, the US economy can absorb the slack.

The IMF opined that the Federal Reserve should wait until next year to hike rates. The Federal Reserve is unlikely to be swayed by the IMF's logic. Fed officials, or at least the leadership, accept some version of the Phillips Curve, which posits that a tighter labor market will boost inflation. The underlying view is that headline inflation gravitates toward core inflation, and labor costs drive core inflation. Labor, like other commodities, is seen driven by supply and demand though a bit stickier. Yellen has argued that she does not need to see core inflation rise much to be reasonably confident that Fed's 2% inflation target (core PCE deflator) will be reached in the medium term, as long as the labor market slack is being absorbed.

The most important US economic data in the coming days will be the May retail sales data. Recall that after the strongest report in a year in March (1.2%), US consumers rested in April and retail sales were flat. They returned in May. The headline rate will be flattered by the strong auto sales that have already been reported. The components used for GDP calculations are expected to rise 0.5%. The monthly average in Q1 was 0.02%.

Assuming the a consensus report in May, and a flat June, the monthly average in Q2 would be 0.16%. What this means is that consumption is likely to be a bigger contributor to Q2 GDP than Q1, and we have already learned that trade is exerting a smaller drag. The Atlanta Fed GDPNow model says the US economy is tracking 1.1% Q2 GDP, and this is likely be revised higher after the retail sales report.

Another driver for the US dollar has been the dramatic sell-off in European bonds that pushed yields sharply higher. As the long positions are unwound, the short euro hedges are bought back. There are two issues here: the direction of yields and pace of the move. German bunds appear to be at the heart of the matter. The rise in German yields had a knock-on effect throughout the capital markets. The German 10-Year yield approached zero in the middle of April, which culminated a multi-year decline in yields. The last leg down in yields was sparked by European inflation falling into deflation territory.

There were also supply and demand dynamics at work. The grand coalition in Germany had agreed to a balanced budget and paying down debt this year. This curbed supply at the same moment that demand was increasing. The increase in demand is partly a function of its safe haven status given the ongoing Greek drama. German bunds are also used as collateral, not just an investment. The launch of the ECB's sovereign bond-buying program is another source of demand.

The decline in the interest rates, the euro and oil prices fueled an economic recovery in the euro zone. At the same time that the economy gained traction and credit growth expanded, oil prices began recovering. This reduced the deflationary pressures. April's CPI was flat, and the preliminary May report was the first positive reading (0.3%) since last November.

If economic fundamentals explain the direction, what about the pace of the move? In mid-April, many had expected the 10-year German bund yield to go negative, but it stopped just below five bp. Three weeks later it was near 80 bp and a half week later (last week) it approached 100 bp. There appear to be several factors at work. First, as Draghi noted, the low yields themselves leave the market more subject to volatility. Second, the micro-structure of the market, with levered players using some variant of value-at-risk models, exacerbates movement.

As yields and volatility fall, such participants take larger positions only to have to scramble out when vol increases. Thirdly, a combination of technology, regulation, and central bank activity appears to have contributed to the fragmentation of the market which, while often generating strong volumes, diminishes liquidity. Draghi's failure to express much concern (instead he advised investors to get used to it) may have helps spur new selling.

The unresolved Greek crisis also keeps the market on edge. The official creditors made an offer to Greece, which was very much in line with the "pretend and extend" strategy. The Greek government summarily reject it. The Greek government gets little sympathy from the political elites and investor class. Nevertheless, its demand for debt relief is more realistic than pretending that its debt is sustainable. Even the IMF has called for debt relief though it wants to exclude itself from the process. It is willing to be more generous with EU money than with its own.

The Greek government has consistently maintained that it comes down to a political decision. It has been accused of trying to do an end run around the Eurogroup of finance ministers. To the extent that the creditors finally offered their own proposal after Greece has submitted no less than three plans, this came about only with the intervention of officials at the highest level.

As European officials did in 2010-2011, once again they want to make an example of Greece. They want to send a message that there is no alternative to the diktat of austerity. But there is. It is called debt relief. This can take the orderly form of restructuring that EMU officials have permitted for private sector investors in Greece and Cyprus. It can take a less organized form of default. The more onerous the demand for austerity and refusal of the official creditors to devise a plan for debt restructuring, the more likely is a default. A default under current conditions would make the Argentinian crisis look like a tea party. Greece may very well have been dysfunctional before the crisis, but the cost to Europe of turning it into a failed state would be much higher than debt relief.

The dollar has rallied nearly 6% against the yen from the low seen on May 14 (~JPY118.90) to the high seen before the weekend (~JPY125.85). Absent among the drivers is jawboning by Japanese officials. If anything, government officials have been cautioning against sharp moves. Japanese companies, like Fuji Heavy Industries Ltd. (TOKYO:7270), have indicated that an "overly weak yen is not welcome." The macroeconomic considerations include the rise in US yields and the strong rise in Japanese stocks. Of the major G7 equity markets, the Nikkei is the only one to have rallied (~5.6%) over the past month.

In terms of flows, Japanese investors had stepped up their purchases of foreign bonds after early May. Before turning to small sellers in late May, Japanese investors had bought nearly JPY2.5 trillion of foreign bonds in the preceding three weeks. Japanese pension funds are diversifying away from the JGB market, toward domestic equities and foreign bonds. The yen has reached levels at which some asset managers are reevaluating whether they want to continue buying foreign bonds on an unhedged basis.

Speculators also have been exceptionally aggressive sellers of the yen over the past three weeks. We cite these figures from the speculative positioning in the futures market, assuming that they are representative of that market segment of short-term leveraged momentum players.

One needs to appreciate that the dollar-yen was confined to a broad trading range since last December. During this period, the gross short yen speculative positions at in the futures market were cut from 153k contracts (each contract is for 12.5 mln yen) to about 52.3k contracts by late April. This was the smallest speculative short yen position since November 2012. In the past three CFTC reporting weeks, speculators have more than doubled their gross short yen position. As of June 5, it stood at 132.4k contracts. This three-week selling spree is the largest in four years.

Indicative pricing in the options market is interesting. The upside breakout for the dollar has coincided with a decline in implied volatility. The three-month implied volatility has fallen from 10% in late-May to about 8.75% before the weekend.

At the same time, the premium for dollar calls (3-month 25 delta) has fallen from 0.9% to 0.3%. This suggests that instead of buying dollar calls while there is a rally, participants are selling dollar calls. These participants could be long dollars, and using the options market to buy downside protection. It could also be Japanese exporters whose exports to the US have been running more than a fifth above year-ago levels, putting out sell calls against their dollar receivables. Some Japanese investors in US bonds may also be hedging their currency risk.

Japan will offer a revision to its initial Q1 GDP estimate of 2.4% at an annualized pace. The market is divided about the outlook for the revision. The Bloomberg consensus anticipates an upward revision to 2.8%. This would be largely based on the strong upward Q1 caps. Instead of falling by 0.2% as anticipated, it jumped 7.3%. However, there is some risk that inventory accumulation, which accounted for over half of Japan's quarterly growth, will be revised down. Hence, it will be a surprise regardless of the outcome.

Europe will report industrial production data for April. After a weak March (-0.3%), industrial production in the eurozone is expected to have bounced back, with the consensus around 0.4%. However, it is non-eurozone industrial production reports that may be more interesting. Industrial output jumped 0.5% in the UK in March but is likely to have slowed in April. The consensus expects a 0.1% rise though the risks seem on the downside. Sterling has built a small shelf in the $1.5180-95 area (there is other technical support in the area, see here) and a disappointing report, which would play on ideas that the UK economy has peaked, would likely send sterling lower. The next target is the early May lows, a cent lower.

Sweden reports industrial output and CPI figures. The consensus is for a 0.2% increase in industrial production, but we see risk on the upside. We look for the Swedish krona to be particularly data sensitive as the market is not convinced that the Riksbank QE is over. The CPI figures are expected to show that Sweden is still experiencing deflation, but it appears to be diminishing.

At the same time, poor Norwegian industrial output figures (-4.9% month-over-month in April and a 2.9% fall in manufacturing output) has heightened speculation of a Norges Bank rate cut at the June 18 meeting. Softness in this week's CPI report will only fan such expectations. The Norwegian krone broke down last week against the Swedish krona. Although it looks over-extended, the Nokkie is still vulnerable.

The Swiss National Bank meets on the same day as the Norges Bank. It will likely confront a strengthening of deflationary forces as the franc's appreciation following the lifting of its cap continues to filter through the economy. With the risk of disruptive developments from the eurozone, the Swiss franc appears poised to strengthen against the euro. Although Swiss officials have indicated that they are near the lower limit of rates, with a minus 75 bp 3-month LIBOR target, there may be scope for a lower target, within the existing -1.25% to -0.25% current range.

The Reserve Bank of New Zealand meets on June 10. The cash rate currently stands at 3.5%. The OIS market is discounting roughly a 50% chance of a cut. We had been leaning more in favor of a cut, but the 7.25% decline in New Zealand dollar against the US dollar since mid-May may have removed some urgency. It finished at new multi-year lows against the dollar. We are concerned that the RBNZ either disappoints those looking for a cut or that there is a sell-the-rumor, buy-the-fact type of activity.

China reports its slew of monthly data. On balance, the real sector is expected to have stabilized. That includes industrial production, retail sales, and investment. China's imports and exports likely remained soft (declining on a year-over-year basis), but this may result in a wider surplus. Yuan loans and aggregate financing likely remained robust. Perhaps the most important report is the CPI. Disinflationary, if not deflationary pressures are still evident. The pace of increase in consumer prices has been halved since the recent peak in October 2013 at 3.2%. Food prices are masking the decline in consumer prices. Non-food prices are increasing by less than 1%. A sharp slowing in the CPI (consensus is for 1.3% after 1.5% in April) may signal higher real interest rates, to which PBOC officials have been particularly sensitive.

The Mexican mid-term, and Turkey's national elections were held yesterday. The results are not yet available. In Mexico, since the President cannot stand for re-election, the significance is about the legislative agenda for the next three years. The peso finished last week at record lows against the US dollar. In Turkey, the issue is whether the ruling AKP wins a super-majority that would give Erdogan a mandate to lead the country even further away from its secular and pro-European path. It does not appear that he will get such a mandate. If these results are borne out, the USD/TRY and Turkish assets may perform well at the start of the week.