Dollar Rally Needs This To Happen

What the Dollar Needs to Rally

The U.S. dollar traded lower against all of the major currencies Monday. While a decline in the manufacturing PMI index from Markit Economics may be blamed for the weakness, the data had very little to do with the sell-off in the greenback. Instead the slide in the dollar and rise in high beta currencies coincided perfectly with the intraday reversal in U.S. stocks. The only problem is that there was no catalyst and clear explanation for the rebound in equities. Generally speaking, investors are optimistic that economic activity will improve as we head into the second quarter. For many countries around the world, there were bright spots in Monday's weaker economic reports. In the U.S. for example, consumer spending and job growth is improving despite a slowdown in manufacturing. In Europe, weaker activity in Germany was offset by a recovery in France. In Asia, speculation of additional stimulus from the Chinese central bank raised hope for more support for the region.

However in order for the dollar to rally, we need unambiguously strong U.S. economic reports and weak data from other countries. There are a number of U.S. data scheduled for release this week but chances are, they will fail to satisfy investors. Each one of these reports will provide us with a clearer assessment of the U.S. economy but none of the reports are major market movers for the greenback. We have the S&P CaseShiller house price report, consumer confidence and new home sales scheduled for release on Tuesday. The flattening of the yield curve that many investors were looking at Monday is an example of a market that is desperate for a big surprise in U.S. data. While we believe that the dollar will trade higher in the coming months months, consolidation and range trading is more likely this week. More significant economic reports will be released the first week of March and that is when we expect a larger move in the dollar. All of this week's reports are second tier. Keep an eye on Treasury yields. Fed Presidents Lockhart (non-voter) and Plosser (voter) will be speaking on Tuesday. As one of the more hawkish members of the FOMC, Plosser should approve of continued tapering and Yellen's view that rates will start to rise 6 months after QE ends.

EUR: Unfazed by Weaker PMI

Despite softer economic data and more sanctions on Russia, the euro recovered earlier losses to end the day higher against the U.S. dollar. According to the latest PMI numbers, economic activity grew at a slightly slower pace in the month of March. Unlike the past few months where growth was led by Germany and dragged down by France, this month the reverse was true in the manufacturing and service sectors. The improvement in the Eurozone's second largest economy was significant enough to offset most of the deterioration in its largest economy and this explains why the Eurozone composite index dropped only marginally. In other words, Monday's economic report does not pose a major risk to the Eurozone outlook or the euro. The German IFO report is scheduled for release T and based on the decline in the ZEW survey and PMI, we have good reasons to believe that the data will surprise to the downside. However the more interesting question is whether a weak IFO would have any lasting impact on EUR/USD. Like the PMI, we still expect an initial reaction but whether the move lasts will depend on the extent of the surprise. For the time being, EUR/USD appears to have stabilized above 1.3750. Aside from the German IFO report, ECB President Mario Draghi is also scheduled to speak on Tuesday. If the head of the central bank makes any fresh comments about monetary policy or the economy, it could affect how euro trades. In the meantime, the euro like many other currencies is taking its cue from U.S. equities. The intraday recovery in stocks coincided with the rally in EUR/USD.

GBP: Downside Risk in CPI

The British pound started its busy trading week steady against the U.S. dollar and lower versus the euro. With inflation, retail sales and revisions to Q4 GDP on the calendar, it should be an active week for the currency. GBP/USD in particular recently broke below 1.65 and is currently struggling to figure out if this key level will become support or resistance. Where sterling heads next will depend in part on Tuesday's UK consumer price report. Like the European Central Bank, the Bank of England is worried about low inflation. This is one of the primary reasons why they maintain an ultra dovish monetary policy outlook despite more signs of a broader recovery. However within the central bank policymakers differ on how quickly inflation will rise. If Tuesday's CPI report surprises to the downside, sterling could extend its losses towards 1.64. Stronger price pressures on the other will take GBP/USD back above 1.65. A rebound in CPI is expected after the previous month's steep decline but based on the British Retail Consortium's report of lower shop prices the risk is to the downside.

AUD: Driven Higher by Speculation of Chinese Stimulus

According to the most recent HSBC Flash manufacturing PMI report, China's economy slowed further in the month of March. Normally, weaker economic activity in the world's second largest economy hurts risk appetite and drives the Australian dollar lower, but on Monday, not only was the AUD the best performing currency, but U.S. stocks held up well. When the report was initially released on Sunday, Australia's currency weakened but rampant speculation that China could respond with accelerated stimulus quickly reversed the move. Although the People's Bank of China knew their economy would slow this year, the pace is quicker than anticipated. When combined with recent defaults, slower income growth and the modest recovery abroad, the central bank has a lot to be concerned about. According to the HSBC report, manufacturing activity contracted at its fastest pace since September 2012. By widening their trading band and allowing the Chinese Yuan to fall to its lowest level in a year, the Chinese government is already taking steps to support their economy and they are prepared to do more. Just last week, China's State Council pledged to "quickly push out already-decided measures to expand domestic demand and stabilize growth." These steps will include "construction on major investment projects" such as affordable housing, infrastructure (railway projects) and energy along with loosening access to private sector investment. They will also "quickly spend funds allocated in the budget." We think the Chinese government has made it quite clear that they are considering accelerating fiscal stimulus but we do not expect any fresh monetary stimulus in the near term. The PBoC may allow the Yuan to weaken further, which would provide relief to exporters and keep rates low but that's the extent of monetary adjustments. What is good for China is good for the rest of the world. If the Chinese government were to officially announce an earlier rollout of these stimulus measures, not only would it promote further gains in currencies of countries reliant on Chinese demand like the Australian dollar but it would also boost risk, allowing for a stronger rise in global equities.

JPY: Keeping an Eye on Consumer Spending

The Japanese Yen (JPY/USD) ended the day slightly lower to unchanged against all of the major currencies. The overnight rebound in the Nikkei provided zero support to Yen crosses. It was only after U.S. stocks recovered intraday did the Yen crosses move from negative to positive territory. Supermarket sales were the only piece of Japanese data released over the past 24 hours and according to the report, consumer demand rebounded in the month of February. However later this week we will receive a series of additional spending reports that are not expected to show the same strength as last night's release. Don't be mistaken, consumer spending is rising ahead of next week's tax hike but Thursday's reports are expected to show slower growth. Whether the central bank responds with additional easing depends less on this month's economic releases and more on Q2 reports. While we believe the Bank of Japan will need to increase stimulus later this year, policymakers are optimistic about the economy and have been reluctant to do so. Small business confidence was due out Monday evening and we were looking for a small improvement.

Kathy Lien, Managing Director of FX Strategy for BK Asset Management.