Dollar: Lifted By Yields, Tempered By Unimpressive Data

The rise in Treasury yields and rally in U.S. equities suggests that investors have grown slightly more optimistic about the outlook for the U.S. economy. However there is very little reason for the outlook to improve given this morning's mixed U.S. economic reports. Weekly jobless claims rose more than expected but when you average the data, the four-week moving average dropped to its lowest level in more than five years. Leading indicators rose at a faster pace but manufacturing conditions deteriorated and house price growth slowed. These mixed reports are indicative of an uneven U.S. recovery that should raise questions about how much the Fed will really taper given the risks that it poses to the already vulnerable economy. Nonetheless investors around the world have their eyes locked on the 3% mark for 10-year yields. We are now only 10bp away from that level and as long as U.S. data isn't terrible, it should only be a matter of time before 3% is reached and while we wait for that to happen, the dollar should remain bid.

Fed President Fisher who is not a voting member of the FOMC this year said Thursday the Fed should taper next month if the economy is strong. So far no comments have come out of the annual monetary policy symposium in Jackson Hole, which began Thursday and goes until Saturday. We will continue to watch the newswires, but market-moving comments should be limited because Fed Chairman Ben Bernanke won't be attending. Two months ago, he dismissed the significance of the meeting by saying, "There's a perception that the Jackson Hole conference is a Federal Reserve system-wide conference; it's not" and therefore no fireworks are expected. U.S. new home sales are scheduled for release Friday and a small pullback is expected in July after a strong rise in June. Given the sharp increase in existing home sales, any drop in new home sales should be limited.

In terms of Thursday's reports, U.S. manufacturing activity slowed in the month of August according to Markit. This release is not as closely followed as the ISM report but still provides an updated assessment of how the sector is doing. Jobless claims rose to 336k from 323k while continuing claims hit 2.999 million, up from 2.970 million. Even with the increase, jobless claims remain at healthy levels with the four-week moving average dropping to its lowest since November 2007. Fewer firings may not translate into stronger hiring but for the Fed, this report won't raise any new concerns about labor market activity. House prices grew at a slower pace in June but the increase was stronger than expected and the past month's report was revised higher. Finally leading indicators rose 0.6% in July against expectations for a 0.5% rise. In other words, Thursday's economic reports were unimpressive.

EUR: EZ Recovery Gains Momentum
As the U.S. continues to report uneven economic data, there is more evidence that the euro-zone recovery has gained momentum. According to the latest PMI reports, the manufacturing and service sector in Germany expanded at a faster pace in the month of August, helping to boost activity in the overall region. The euro zone PMI Composite index rose to 51.7 from 50.5, its highest level in two years. This was the first time in 18 months that the service and manufacturing activity expanded, which is a solid confirmation of the euro zone rising out of recession. The numbers look good based on the headline release alone, but not all euro-zone countries enjoyed the same expansion as manufacturing and service sector activity in France continued to contract. Thankfully growth in Italy, Spain and Ireland helped to make up for the difference. We still need to see additional improvements in PMI to call this a new trend, but the data is moving in the right direction and this has lent support to the euro. After dropping below 1.33 intraday, EUR/USD enjoyed a nice recovery that left the pair unchanged on the day. German GDP numbers are scheduled for release Friday but these final figures are not expected to have a significant impact on the euro. Instead, the upside surprise in euro-zone data should keep the currency from being hit hard by the prospect of Fed tapering.

GBP: MPC Member Talks Possibility For More QE
The British pound backed off the 1.57 level after monetary policy committee member Martin Weale said more Quantitative Easing could be needed. These comments come as a surprise not only because economic data has been strong but because Weale is considered one of the more hawkish members of the MPC. Unlike Fisher and Miles who has voted for more asset purchases on a number of occasions, Weale has generally sided with the majority expect when it came to the latest decision on a threshold. However he voted against the threshold because he wanted to "register his preference for a time horizon for the first inflation knockout that was shorter than proposed." Thursday in an interview with the Daily Telegraph, he said the MPC should not take the recovery for granted and he would not rule out more QE because he can ""certainly envisage circumstances in which it would be sensible to undertake further asset purchases." The market interpreted these comments to be dovish and drove sterling lower as a result. While we don't feel that more QE is on the horizon, Thursday's comments from Weale suggest that the recent improvements in U.K. data have not convinced most MPC members to ease their foot off the pedal. Revisions to Q2 GDP numbers are scheduled for release Friday and no changes are expected. The data should confirm that the recovery in the U.K. accelerated in the second quarter.

CAD: Breaks 1.05 On Retail Sales
The Canadian dollar dropped to its lowest level in more than two months on the back of weaker-than-expected economic data. Canadian retail sales fell 0.6% in the month of June after rising 1.8% the previous month. USD/CAD broke through the 1.05 level in response and now appears to be poised for a test of the July highs above 1.06. Economists had been looking for spending to decline but only by 0.4% and excluding autos, they believed sales would be flat. Unfortunately core retail sales was even weaker than the headline report, falling 0.8%. Part of the decline in consumption can be attributed to the floods in Alberta but steep job losses and a recent downturn in Canadian data suggests that labor market weakness is indicative of a broader slowdown in Canada's economy. On balance, retail sales are expected to provide a smaller contribution to GDP growth in Q2. As for the month of June, a contraction in GDP is now expected. The New Zealand dollar also ended the North American trading session lower despite the recovery in the Australian dollar. Australian leading indicators declined in June but the AUD benefitted significantly from the rise in manufacturing PMI. For the first time since April of this year, HSBC reported an increase in manufacturing activity. While the government's official index had been reporting expansion every month for the past 10 months, HSBC's measure has been far more conservative. Unfortunately weak domestic conditions leaves the door remains open for another rate cut by the RBA. AUD/USD has a chance of rebounding to 92 cents in the near term but further gains beyond that level may be limited. With no Chinese, Australian or New Zealand data on the calendar Friday, the focus should remain on the Canadian dollar. Consumer prices are scheduled for release from Canada and a small uptick in price pressures is expected.

JPY: Japanese Investors Halt Purchases Of Foreign Bonds
USD/JPY appears to be finally waking up and reacting to the rise in U.S. yields. The currency pair staged its strongest rally in more than a week and its gains helped to lift all of the Yen crosses in the process. The biggest mover was AUD/JPY, which benefitted from the simultaneous rally in USD/JPY and the AUD/USD. The Ministry of Finance released its weekly portfolio flow report last night and the latest numbers show that after six weeks of buying foreign bonds, Japanese investors were net sellers. Last week, Y903.8 billion bonds were sold compared to more than Y1.5 trillion worth of demand the prior week. While the amount of sales is significant, we will have to wait and see if it becomes a new trend. We feel that this is unlikely because the spread between U.S. and Japanese yields continue to widen. Meanwhile concerns that Japan's recovery could be losing momentum was eased by a Reuters survey that found manufacturing activity improving in the month of August. Reuters' large manufacturing Tankan report index rose to its highest level since November 2010. The outlook component of the report also increased, suggesting further recovery in the months ahead. There were broad based improvements according to the details of the report with a tinge of weakness in demand from emerging markets. No Japanese economic reports were scheduled for release Thursday evening and therefore USD/JPY could take its cue from the market's appetite for U.S. dollars.

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