The USD And Why Yellen Was A Success

Janet Yellen should be proud of her performance on Capitol Hill Thursday. There are many people who will criticize her intelligence and qualifications as the next Federal Reserve Chairman, but we feel that the confirmation hearing was a big success. The reason is because Yellen managed to get through 2 hours of questioning on very sensitive issues without triggering any big moves in the financial markets, which is exactly what a central bank governor needs to do. Granted the question and session was not nearly as hostile as it could have been, this also suggests that she will easily gain the support from both parties to secure her role. At this stage, her confirmation as the next Fed Chairman is a foregone conclusion.

Yellen also did not waver from her commitment to promoting a stronger recovery and made it clear that she does not support an early withdrawal of stimulus. In her own words, Yellen said it is "important not to remove support too soon" and there are "dangers of ending QE too quickly." It is therefore clear that she will say no to tapering in December. However the decision in December is not hers but Bernanke's and this reasoning may have helped the dollar hold onto its gains. According to Yellen, there is no set time for tapering QE and right now, the benefits of the bond-buying program still outweigh the costs. The rally in U.S. equities and decline in Treasury yields tell us that investors are satisfied with her responses. The only reason why the dollar did not move lower is because there were no surprises in Yellen's testimony and most importantly, she said nothing to change the market's expectations for tapering in the next 4 months. If U.S. data continues to surprise to the upside, rates will move higher and that will be positive for the greenback. The inevitability of a reduction in asset purchases suggests that we have not seen the last of the dollar's gains.

Meanwhile this morning's U.S. economic reports had very little impact on the greenback. Jobless claims dropped from an upwardly revised 341k to 339k while the trade deficit rose to -$41.8B from -$38.7B in the month of September. Despite the improvements in the ISM manufacturing index, exports dropped for the third consecutive month, reflecting the potential weakness in global demand. Domestic demand on the other hand is showing signs of improvement with imports rising 1.2%. On Friday, the Empire State manufacturing survey and industrial production are scheduled for release but none of these reports are expected to have a dramatic impact on the dollar.

GBP: Unfazed By Weaker Retail Sales
The British pound ended the day higher against the U.S. dollar and euro, after recovering strongly following this morning's weak U.K. retail sales report. Consumer spending dropped a whopping 0.7% in the month of October. While economists had expected consumer spending to stagnate, which would already be pretty bad, no one expected spending to fall as much as it did. Consumers spent less on key items such as household appliances, clothing and gas. Analysts have attributed the decline in demand to the warmer weather but with slow wage growth and a decline in consumer confidence, weather could be only part of the problem. Demand needs to come back strongly in November and December in order to offset last month's decline. Based on the reversal in sterling, investors are certainly hoping that consumers are saving for the holiday shopping season and will spend strongly in the coming weeks. With labor market conditions improving, this hope has a reasonable chance of turning into reality especially after the Bank of England also accelerated its forecast for reaching their 7% unemployment rate target. Compared to the euro zone, the U.K. economic outlook is brighter and with Janet Yellen sticking to her dovish views, we are also seeing additional positional adjustments in the GBP/USD.

EUR: Slower Growth Validates ECB Decision To Ease Despite weaker than expected growth in the third quarter, the euro ended the North American trading session unchanged against the greenback. Euro-zone fundamentals are always important to the currency, but right now the EUR/USD's movements are driven primarily by the market's outlook for U.S. monetary policy. The U.S. dollar held onto its gains after Janet Yellen's confirmation hearing and this kept the pressure on EUR/USD. Of course, weaker euro-zone GDP numbers also did not help the currency but this was more of an afterthought because the initial losses after the GDP report were recovered well before Yellen began to speak. According to the latest economic reports, growth in the euro zone slowed to 0.1% in the third quarter, down from 0.3% in Q2. While this quarterly increase was right in line with expectations, on an annualized basis, GDP growth dropped 0.4% compared to a forecast of 0.3%. Growth in the second quarter was also revised down to -0.6% from -0.4% and this explains why the European Central Bank was so eager to cut interest rates this month. Germany and France experienced weaker growth but improvements were seen in Italy and Spain. This year has been a tough one for the region and with Fridays euro zone consumer price report expected to confirm that price pressures declined in October, the ECB had every reason to accelerate stimulus. Looking ahead, if economic data continues to deteriorate, there's scope for additional easing by the central bank.

USD/CAD Continues To Reject 1.05
The market's demand for U.S. dollars continued to dictate the moves of commodity currencies. The Canadian, Australian and New Zealand dollars traded lower against the greenback Thursday despite upside surprises in economic data. The Canadian dollar should have rallied on the back of stronger trade numbers but it declined instead, retesting the key 1.05 level for the third time this month. Canada's trade deficit shrank more than 50% from 1.31 billion to 435 million in the month of August. Exports rose to their highest level in nearly 2 years thanks to stronger demand for crude oil shipments. Unfortunately the loonie had zero reaction to the release and instead traded quietly until Janet Yellen began to speak. The 1.05 level is proving to be very stiff resistance for USD/CAD and its inability to break beyond this rate suggests that there are some hefty orders above current levels. Meanwhile the Australian dollar was hit the hardest Thursday and this could be partially due to consumer inflation expectations, which eased in the month of November, validating the RBA's dovish bias. The New Zealand dollar on the other hand held up extremely well thanks to better than expected economic data. While retail sales grew less than expected in the third quarter, consumer confidence jumped 5%, rising to its highest level since January 2010 and signaling a potential recovery in spending at the end. With manufacturing activity also accelerating at a faster pace in November, the RBNZ is on track to raise rates next year as the economy continues to improve. The divergence in growth and monetary policy direction between Australia and New Zealand has and should continue to drive AUD/NZD lower.

Yen Crosses Lifted By Japanese Stocks And GDP
With the Nikkei climbing to its strongest level in nearly 6 months, it is no surprise that all of the Japanese Yen crosses traded higher Thursday. GBP/JPY was the best performer, hitting its strongest level since 2009 followed by USD/JPY, which breached the 100 level. Japanese stocks were supported by better than expected third quarter GDP numbers and overnight rise in U.S. stock futures. As economists had anticipated, GDP growth slowed in the third quarter and we explained yesterday that weaker trade activity would be blamed for the slowdown. Consumer consumption also moderated but demand is widely expected to improve in the coming months. So while annualized growth in Japan slowed to 1.9% from 3.8%, the pullback was not as severe as economists feared and the rise in public investment combined with increase inventories still points to a brighter outlook for Japan. The Nikkei's reaction to Japan's GDP report confirms that investors are not worried about weaker GDP growth in Q3 because demand should increase in the coming months before the consumption tax is hiked.

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