Is Taper Lifting The Dollar?

Is Fed Tapering Finally Lifting the Dollar?

The Federal Reserve’s decision to taper asset purchases on Wednesday should have been positive for the U.S. dollar. However the greenback failed to rally on the news because the market was distracted by the turmoil in the emerging markets. The stabilization in the Turkish Lira and South African Rand Thursday took some of the focus off EM FX and allowed investors to consider the U.S. central bank’s recent action. The concurrent rise in the U.S. dollar, S&P 500 and Treasury yields is a sign that U.S. assets are back in demand. According to the fourth quarter GDP numbers, the U.S economy continues to grow at a healthy rate. Although GDP growth slowed to 3.2% from 4.1% in Q4, anything above 3% growth is consistent with a broader recovery. This solid course of growth is one of the main reasons why stocks can rise even as the Fed tapers. Forward guidance is also working because the increase in 10-year yields has been nominal. The rally in U.S. stocks indicates that the dollar is not rising because of a flight to quality. However given that the evolving situation in the emerging markets, risk aversion could still return, posing a risk to the rally in USD/JPY. If that occurs, we will view a sell-off in USD/JPY as an opportunity to buy at lower levels. Friday’s personal income and spending numbers are not expected to have a significant impact on the greenback. The Chicago PMI index and final University of Michigan consumer confidence survey for January are also due for release. Given the improvements in manufacturing conditions in the NY and Philadelphia regions, we are looking for an uptick in activity in Chicago. As long as the data is not terrible, it will justify the Federal Reserve’s decision to taper this week.

Thursday’s U.S. economic reports were mixed. GDP growth slowed to 3.2% from 4.1% in the fourth quarter while jobless claims rose from 329k to 348k. As mentioned earlier anything above 3% GDP growth is healthy and consistent with a continued recovery in the U.S. economy especially when personal consumption growth accelerated to 3.3% from 2%. This was slightly weaker than expected but still a strong reading. When combined with third quarter results, this was the best pace of growth for the second half of the year since 2003. Of course, there are always areas of concern and pockets of weakness with fixed residential investment declining and overall growth slowing but in general, the data was positive for the dollar. The increase in jobless claims would be concerning if not for the potential impact of inclement weather and the MLK holiday. We expect USD/JPY to break 103 in the near term.

EUR: German Data Shows Persistent Problems with Low Inflation

The volatility in emerging markets continues to put pressure on the euro. The currency experienced its largest one-day loss this year and is quickly closing in on the key 1.35 level. The Turkish Lira, South African Rand and Russian Ruble bounced Thursday, but the Hungarian Forint and Polish Zloty continued to fall. We believe emerging market central banks will need to take further action to stabilize their currencies in the coming weeks. Mixed economic data out of the Eurozone failed to help the euro. German unemployment dropped more than expected and this helped to keep the jobless rate at 6.8%. However consumer prices dropped 0.6%, driving the annualized pace of CPI growth down to 1.3% from 1.4%. This is a sign that low inflation remains a big problem for the European Central Bank. There was an improvement in economic confidence in the Eurozone but this was due largely to an uptick in services. Industrial confidence declined alongside the business climate index. German retail sales and the Eurozone’s January CPI estimate are scheduled for release on Friday. Annualized inflation growth is expected to be less than 1% for the fourth straight month. The ECB has a 2% inflation target and the longer CPI remains below 1%, the greater the pressure on the central bank to take additional steps to drive prices higher. If prices increase it would justify their decision to lower interest rates at the end of last year. For the time being, further losses in EUR/USD are likely with the potential for the 1.35 level to be tested in the near term.

GBP: Mortgage Approvals Rise to Highest Level in Nearly 6 Years

The British pound traded lower against the U.S. dollar Thursday but compared to other major currencies, it remains one of the most resilient. Part of that resilience has to do with the overall strength of the housing market and economy. Mortgage approvals rose to 71.6k in December from 70.8k the previous month. This marked the strongest month of mortgage approvals in almost 6 years. Business lending declined but as long as the housing market continues to perform well, the U.K. economy should hold its own. The government’s Funding for Lending and Home to Buy schemes have gone a long way in reinforcing the country’s recovery. As we said in our 2014 GBP outlook, housing, banking and global growth are the engines of growth for the U.K. economy in 2014. We expect sterling to continue to outperform most of the major currencies including the euro and Japanese Yen. There are no additional U.K. economic reports on the calendar this week but next week’s PMI numbers will determine whether sterling has the strength to hit new 2.5 year highs against the dollar and fresh 1 year highs versus the euro.

CAD Drops to Fresh 4-Year Lows Ahead of GDP

For the third straight day, the Canadian dollar dropped to a fresh 4 year low versus the U.S. dollar. Despite a sharp rise in average weekly earnings, investors continue to sell the loonie and if Friday’s Canadian GDP report fails to impress, the pair could break 1.12. We know that the Bank of Canada is worried about the outlook for its economy but the increase in earnings should ease some of their fears. In fact the uptick in earnings translated into stronger retail sales for the month of November, which bodes well for Friday’s November GDP report. Slower growth is still expected however because trade activity deteriorated significantly that month. The Australian and New Zealand dollars moved in completely opposite directions, leading to a 1.25% rally in AUD/NZD. For Australia, stronger terms of trade in the fourth quarter offset weaker Chinese manufacturing activity, softer Australian new home sales and lower prices. AUD has been vulnerable to a short squeeze for some time and Thursday’s price action is a reflection of the adjustments in positioning. The New Zealand dollar extended its losses post RBNZ. Nearly all of the reports that we have read from local economists agree with our view that the language in RBNZ statement puts the central bank closer to raising interest rates in March and yet NZD responded negatively. The only explanation outside of expectations for a rate hike this month is the possibility that some traders hoped the central bank would raise rates by 50bp instead of 25bp in March and there was nothing to support that thesis in the statement. 81 cents is support for NZD/USD. No economic reports were scheduled for release from New Zealand Thursday evening but Australia's fourth-quarter producer price report was on tap.

JPY: Japanese Data Dump

With the rise in U.S. 10 year yields offsetting only part of the losses in the Nikkei overnight, it was a mixed day for the Japanese Yen. The Yen traded lower versus the U.S., Canadian and Australian dollars but extended its gains versus the euro, Swiss Franc and New Zealand dollars. Risk appetite continued to drive the movements in Japan’s currency but the surprise decline in retail sales last month also contributed to the weakness in Japanese stocks. Consumer spending dropped 1.1% in December. Economists expected retail sales growth to slow to 0.3% but they did not anticipate a decline. On an annualized basis, retail sales grew 2.6%, down from 4.1% the previous month. Interestingly, the media focused on the fifth straight year on year rise in retail sales with most saying that consumer spending has been solid ahead of the April sales tax hike. Thursday night’s Japanese data dump was expected to provide everyone with a deeper look at how Japan’s economy has been performing. Manufacturing PMI for the month of January is scheduled for release along side Tokyo consumer prices. For December, we have overall household spending, the jobless rate, industrial production and national consumer prices. The data is expected to show more progress in combatting deflation along with a significant increase in industrial production. Stronger numbers could help the Nikkei recover and drive USD/JPY above 103.

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