Should Investors Stay Long Dollars?

This week we learned that if Janet Yellen becomes the next Federal Reserve Chairman, she will be in no rush to taper asset purchases. Unlike some of her colleagues, she does not believe that inflation is a significant risk at this time and feels that the central bank should wait for additional improvements before removing support. Friday's weaker economic data justifies her dovish bias and leads many investors to wonder if they should stay long dollars. The greenback is trading at its strongest level in more than 2 months and while the break above 100 may be appealing, without fundamental support, the currency pair may find difficulty rising to new highs.

The answer to the question of whether investors should stay long dollars is contingent upon the time frame. We feel confident that the dollar will be trading higher than where it is now against the euro and Japanese Yen in 3 months time and maybe even sooner if data is good. U.S. rates are headed higher and as long as this prospect does not change, we can expect another 2 to 3% rally in the dollar. While we do not expect the Federal Reserve to taper asset purchases in December, January and March are both options. We lean towards the latter but if payrolls growth is strong in November and December, the central bank could begin reducing asset purchases shortly after the New Year.

In the coming week however, there is both downside and upside risk for the greenback. We know that most FOMC officials favor earlier tapering so when the minutes from the last Fed meeting is released, it could be less dovish which would be supportive of the greenback but unfortunately that would only be the case if retail sales turned positive in the month of October. If consumer spending declines for the second month in a row, policymakers will have to abandon their support to taper in December. According to other measures of consumer spending, retail sales last month was weak. Johnson Redbook reported a 1.2% decline in sales in October versus September and while the International Council of Shopping Centers reported a 4.1% year over year gain in chain store sales, this represented only a slight increase from the previous month's 4.0% rise. So we don't rule out the possibility of short-term pain in the dollar before long term gain. A number of Federal Reserve officials are also scheduled to speak including Ben Bernanke and as usual their views on monetary policy can affect the dollar by shaping the market's expectations for Fed tapering.

Behind The Breakout Moves In Yen
We had a number of breakout moves in the forex market this week and they all involved the Japanese Yen. While most traders were focused on USD/JPY's move above 100, multi-year highs were reached in GBP/JPY and EUR/JPY. Yen crosses generally perform well in an environment where U.S. stocks are hitting record highs but the 7% rise in the Nikkei over the past week compounded the gains. Japanese stocks are rallying because of improvements in Japan's economy but the Yen is weakening because domestic investors are shifting their money away from Japanese assets into higher yielding currencies. Over the next 4 to 5 months, the Federal Reserve is expected to start removing stimulus and during this period, the Bank of Japan will consider whether more Quantitative Easing is needed to offset the impact of the consumption tax. This divergence in monetary policy direction is a very clear reason for why USD/JPY should be headed higher. The Bank of Japan meets next week and monetary policy is expected to remain unchanged, posing zero risk to recent moves in the Yen. The sustainability of recent gains will hinge upon the outcome of U.S. and European economic releases along with overall risk appetite.

EUR: Busy Week Ahead
This was a week of recovery for the euro with the currency making higher highs and higher lows against the dollar on a daily basis. From a technical perspective this is a sign of reversal that signals a stronger recovery for the currency pair but the improvement in risk appetite is the only fundamental factor supporting the move. Next week is a busy one for Europe with a number of important euro zone economic reports scheduled for release that will determine whether the euro deserves its recent gains. If the weakness in Q3 GDP growth extends into the fourth quarter, investors may turn on the euro. The most important reports will be the PMI numbers followed by the IFO and ZEW. These releases provide the market with its first look at how the euro-zone economy performed in the month of November. Economists are looking for improvements all around and if they are right, it could lend support to the euro. Between euro zone economic reports, the U.S. retail sales number and the FOMC minutes, it should be a volatile week for the single currency. While the outlook for Europe could have a short-term impact on EUR/USD, we feel that the trajectory of U.S. monetary policy will still be the main driver of EUR/USD flows. In the meantime 1.35 is a psychologically significant resistance level but the more important technical resistance could be at 1.36.

GBP: Supported By BoE Policy
It has been a good week for the British pound. Despite the surprise decline in retail sales, the currency was supported by the Bank of England's less dovish outlook for the economy. The big news this week was the central bank's decision to alter its labor market projections in favor of a faster decline in the jobless rate. According to the central bank's Quarterly Inflation Report, their 7% target could be reached as early the middle of 2015, more than a year sooner than their previous forecasts. The market had second-guessed its own belief that rates would rise in mid 2015 but now their optimistic views are shared by the central bank. Back in August, as part of their new forward guidance policy, the BoE said rates would remain unchanged as long as unemployment is above 7%. As the unemployment rate started to fall, investors began to price in an earlier rate hike and their positioning drove the GBP/USD to 1.6260 in early October. Since then sterling gave up part of its gains as weaker economic data started to pour in, causing investors to question their hawkish views but with the official changes in the BoE's forecasts, the currency could see a stronger recovery. In order to temper the currency's rise, Bank of England Governor Carney made it clear that interest rates will not increase automatically when the unemployment rate drops to 7%. Instead he wants to see real incomes rise and the recovery on stronger footing before tightening monetary policy. However as long as data continues to improve, it may be difficult to hold back market expectations. Sterling even rallied after the retail sales report because stronger labor market conditions gave investors hope that consumers are saving for the holiday shopping season. It won't be long before we get to see whether that is true. In the meantime, next week will be a quiet one in the U.K. with only the BoE minutes scheduled for release. No surprises are expected because all of the significant announcements were included in the Quarterly Inflation Report and this means the market's appetite for dollars and euros should dictate the performance of the pound.

AUD: Optimistic About China's Reform Plans
The Australian, New Zealand and Canadian dollars rose strongly against the greenback Friday despite mixed data from Canada. Existing home sales dropped 3.2% in October while manufacturing sales rose 0.6% in September. Investors in general are optimistic about the outlook for China after the government released its reform plan details. While the most talked about announcements are the relaxation of the one child policy and end to labour camps, China also gave farmers greater rights, promised to proactively develop mixed ownership, allow employees to hold shares in those companies, allow non-state investment into state projects, set up free trade zones, exempt most corporate projects from government approvals and transfer 30% of profits produced by state owned enterprises to public finances to improve the well being of their citizens. The goal is to make China's growth more sustainable and based on the reaction in equities and currencies investors believe that encouraging private investment will help stabilize China's economy. China's outlook will continue to affect currency flows in the coming week with the release of HSBC's flash PMI report. The minutes from the last RBA meeting is also due for release along with Canada's retail sales report.

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