Is The Fed Gunning For The USD?

The U.S. dollar either held steady or traded higher against all of the major currencies Thursday with the exception of the euro, which rebounded on the back of stronger German employment. The latest U.S. economic reports were mostly better than expected helping the greenback recapture earlier losses but the main focus Thursday were the comments from Federal Reserve officials. Fed Presidents Dudley, Powell and Lockhart spoke Thursday and with the first two being voting members of the FOMC this year, its no surprise that their comments triggered intraday volatility in the dollar.

All three Fed Presidents said that it may be appropriate for the central bank to taper asset purchases in 2013 and end QE buying in mid-2014 but the markets chose to hone in on Dudley's comment that QE depends on the economic outlook and not the calendar and could be prolonged if the economy misses their forecasts. There's no question that the recent rise in U.S. yields has irritated central bankers but the fact Dudley still repeated Bernanke's timing after qualifying the conditions for QE means that this uber dove is most likely onboard with the idea of reducing asset purchases. Fed President Powell's stance was similar -- while he sees the central bank scaling back purchases this year, he said it is data and not date dependent. Both Dudley and Lockhart didn't see Bernanke's press conference last week as a strong signal of Fed policy or a major shift but rather a "soft notion" of when QE could end.

We don't think dollar bulls need to be worried about the Fed backtracking on their words because their message is in our opinion, pretty clear. They want to start reducing the amount of stimulus but they need to manage expectations carefully to avoid another spike in yields that could threaten their overall efforts. It is no surprise then that they are trying to downplay the significance of what Bernanke said last week. At the end of the day however, the central bank is still getting ready to taper, which is positive for the dollar.

Thursday's U.S. economic reports confirm the economy is equipped to handle less stimulus. Most of the data were in line with expectations with personal incomes growing 0.5% and personal spending growing 0.3%. The healthy trend of stronger income versus spending is a dynamic that the Federal Reserve will be very happy with because it signals that Americans will be more frugal with their spending. The PCE deflator rose 0.1%, which suggests that inflationary pressures are beginning to increase. Jobless claims on the other hand dropped from 355K to 346K, a number that is generally consistent with a continued recovery in labor market. Pending home sales jumped 6.7% last month, enjoying its strongest gain in more than 6 years. The Chicago PMI index and final University of Michigan Consumer Sentiment numbers are due for release on Friday but our primary focus will be on Fed President and FOMC voter Stein's comments on monetary policy.

EUR: Holds 1.30 Thanks To Stronger Data
After selling off for two consecutive trading days, the euro rebounded against the U.S. dollar. Better than expected economic data reduced the possibility of further easing by the European Central Bank. According to the latest German unemployment numbers, the labor market in the euro zone's largest economy is recovering gradually. Unemployment rolls dropped by 12K in June compared to a rise of 17K in May and a forecast for an 8K increase. The unemployment rate held steady at 6.8% but only after a downward revision to the prior month's report. Confidence also appears to be improving with the Euro Zone Economic Confidence indicator rising to 91.3 from 89.5. Like the ZEW and IFO reports, there was some underlying weakness, this time in the service sector but the deterioration was masked by improvements in other parts of the economy. The unevenness of the euro-zone recovery will encourage the ECB to maintain a bias to ease when they meet next week. We firmly believe that ECB President Draghi will repeat that the central bank stands ready to act if necessary. Unlike the Federal Reserve, the Europeans are not even thinking about reducing stimulus at this time. German and French consumer spending numbers are scheduled for release Friday and spending in both countries is expected to improve. In fact, the German PMI index hit a 16-month high in June and along with the drop in unemployment, we have good reasons to believe that spending improved last month.

GBP Slips After Downward Revision To GDP
The British Pound weakened against all of the major currencies following a downward revision to first quarter GDP. While quarterly GDP growth held steady at 0.3%, year over year GDP growth grew 0.3% compared to a prior forecast of 0.6%. The economy is showing signs of strength after contracting in the first quarter and even with the downward revision, the country avoided a double dip recession. The Office for National Statistics revealed that disposable income plunged 1.7%, the most since 1987 following a 0.1% increase in the fourth quarter. The decline was mainly due to a fall in wages. The ONS said that the economy stagnated in the first quarter in 2012 instead of an anticipated fall of 0.1%. Data revealed that economy shrank 7.2% from its peak in 2008, more than the 6.3% previously estimated. The first quarter GDP was anticipated to have been 3.9% lower than the pre-financial crisis peak in the first quarter of 2008. This was worse than the previously reported 2.6% contraction. The ONS also reported that the current account deficit widened to 14.5B pounds from 13.6B pounds. Bank of England Governor Mervyn King said earlier this week that, "It would be sensible to aspire to a pace of recovery that would bring unemployment back to a sustainable rate over the two-to-three-year horizon. There is a recovery, but my view is that it's not sufficiently rapid enough" - apparently he is right. Consumer confidence and Nationwide House Prices are scheduled for release over the next 24 hours.

AUD: Vulnerable As Gold Tests 1200
All three of the commodity currencies held steady against the U.S. dollar as gold flirted with the $1200 level. As one of the world's major gold producers, Australia's currency has a strong correlation with the price gold which has been getting clobbered in recent weeks. The yellow metal dropped another 2% Thursday, making the Australian dollar vulnerable to additional losses despite the rise in Chinese industrial profits and steady SHIBOR rates. The only piece of economic data released from Australia overnight was job vacancies, which eased in the month of May. Private sector credit is scheduled for release this evening. The New Zealand dollar also rebounded against the greenback but the gains were modest because of mixed economic data. The country's trade surplus shrank significantly last month due to a surge in imports but exports were strong and business confidence increased. We doubt that this positive sentiment can be sustained given the recent strength of the NZD versus the AUD. The focus Friday will be on the Canadian dollar with CAD GDP scheduled for release. The Canadian economy expanded by 0.2% in March and is forecasted to have grown 0.1% in April. BoC Governor Stephen Poloz said earlier this month that Canada's economic recovery will take "stability" and "patience." Poloz said reviving business confidence is vital to Canada's expansion. A report by Export Development Canada revealed that Canadian exporter confidence has risen as companies become less bleak about US and European demand and more confidence has been instilled in their ability to manage that their currency is riding close with the US dollar. It's semi-annual trade confidence index rose to 72.6 from 70.7. EDC chief economists Peter Hall said, "Exporters are telling us that they feel the worst may be over in Europe, that US customers are ordering more, and that they are optimistic that world markets will turn a corner in the next six months."

JPY: Busy Night For Japan
The recovery in global equities helped to drive the Japanese Yen lower against all of the major currencies. The rebound in the Nikkei also supported USD/JPY which managed to end the day above 98 for the first time in two weeks. According to the Ministry of Finance's latest portfolio flow report, Japanese investors continue to sell foreign bonds. This was the largest amount of net sales in one week since April 2012. The argument is that with an aging population, Japanese investors have a growing need to bring money home and this behavior is creating an inherent demand for Yen and counteracting downward forces. Rising U.S. yields may make U.S. assets more attractive but the performance in Nikkei is also encouraging investors to keep money domestic. Thursday night was shaping up to be a busy one in Japan with manufacturing PMI, overall household spending, the jobless rate, consumer prices, retail sales and industrial production numbers scheduled for release. Of these reports, industrial production will probably be one of the most market moving since it is a leading indicator of broader economic activity.

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