USD Takes Charge As Data Skews Fed Expectations

Last week we saw very little consistency in the dollar's performance but that changed Monday with the greenback clawing higher against all of the major currencies with the exception of the NZD. Earlier losses were recovered by the end of the North American trading session thanks to a stronger than expected ISM manufacturing report that shifted expectations for Fed tapering. This is a busy week for U.S. data and many of the Tier 1 reports on this week's calendar has the potential to skew market expectations. The simultaneous rally in the dollar, rise in bond yields and decline in stocks tell us that investors are encouraged by Monday's release and are putting some of their bets on the possibility of tapering in December. USD/JPY is one of the biggest beneficiaries of the demand for dollars and while the pair is struggling to extend its gains above 103, this pause should be temporary.

As the week progresses, the dollar should remain in charge of price action although Tuesday's risk appetite could dominate simply because there are no U.S. releases on the calendar. Traders should keep an eye on U.S. yields because the dollar will take its cue from Treasuries. Since investors are still divided on when the Federal Reserve will taper (December, January or March), this week's economic reports will play an important role in shaping market expectations, starting with Monday's ISM manufacturing index. Despite weaker manufacturing activity in the NY, Philadelphia and Chicago regions, manufacturing production accelerated across the nation with the ISM index rising to 57.3 from 56.4. This was the strongest pace of growth since April 2011 and the rise in orders in particular is very positive for the U.S. recovery. If non-manufacturing ISM and non-farm payrolls reports also surprise to the upside, investors will skew their positions for December tapering, leading to further gains in the dollar.

With the U.S. government shutdown ending in October, this month's NFP report was originally expected to show a snapback in job growth. However last month's 204k rise in payrolls exceeded the expectations of the most optimistic economist and because of that everyone is now looking for job growth to slow in November. If they are wrong and payrolls rise by more than 200k (190k would even do the trick), the unexpected strength of the labor market will prompt traders to readjust their positions for earlier tapering, compounding the gains in U.S. yields and the dollar. In fact, an upside surprise in non-farm payrolls report could be just what USD/JPY needs to break its 4-year high of 103.74 but the breakout could occur sooner if the leading indicators for NFPs point to a stronger number.

Will The RBA Drive AUD/USD To 90 Cents?
While the central focus of the foreign exchange market this week is on the U.S. dollar and Friday's non-farm payrolls report, this is also a very big week for the Australian dollar. Aside from Chinese and Australian PMI reports, a RBA meeting, retail sales, GDP, current account and trade reports are also on the calendar. The last time we heard from the central bank, their level of dovishness and concern about their strong currency caught the market by surprise. Since then, the AUD/USD has been on a one-way downtrend from 95 cents to 91 cents. The RBA, which was due to issue its monetary policy announcement Monday evening will be relieved to see the decline but that may not be enough to ease the minds of policymakers. The big problem is that economic activity in Australia and China slowed. China's official PMI index remained unchanged but an earlier report from HSBC showed slower growth in the manufacturing sector. In Australia, manufacturing activity contracted last month with the PMI index dropping to 47.7 from 53.2. Building approvals also fell 1.8% while house prices grew a mere 0.1%. Before the RBA announcement Monday evening, retail sales and current account figures were due for release amidst deteriorating expectations. This will make it difficult for the RBA to be optimistic and there's even a small chance that the central bank could suggest that another rate cut is possible which would be extremely negative for the AUD/USD. If the RBA increases their level of dovishness, AUD/USD could drop to 90 cents. If the statement remains unchanged, we expect a much needed relief rally. The best performing currency on Monday was the New Zealand dollar, which rose 0.8% against the greenback. In contrast to Australia, economic data from New Zealand has consistently surprised to the upside. The country's terms of trade index rose 7.5% to its highest level in nearly 40 years. This divergence between Australia and New Zealand has and will continue to drive AUD/NZD to new lows. Meanwhile, USD/CAD climbed to its highest level in 2 years. The persistent weakness of the CAD is d a byproduct of USD strength because no Canadian data was released and oil prices rose 1.28%.

EUR: Hit By Dollar Strength
Next to the Japanese Yen the euro worst-performing currency Monday. Even during the early North American trading session when all high beta currencies were trading higher, the euro lagged behind. Considering that the composite euro zone PMI manufacturing index was revised higher for the month of November, the currency pair should have rallied. However EUR/GBP selling and the downward revision in Spain's PMI index kept the currency under pressure. Manufacturing activity was revised upwards for Germany, France and Italy but with the contraction in Spain deepening, the divergence in growth within the region remains an area of concern for investors. The bigger risk is that the ECB will share these fears and remind investors they are ready to increase stimulus if needed. With improving U.S. data hardening the case for December tapering, the dovish bias of the ECB was bound to drive EUR/USD lower. We continue to look for the currency pair to drop to 1.33 and possibly even 1.32. Euro zone producer prices are due for release Tuesday and inflation is expected to decline, validating the central bank's dovish bias.

GBP: Supported By Upside Surprise In PMI
Stronger than expected manufacturing data drove the British pound to a 2-year high against the U.S. dollar but unfortunately sterling failed to hold onto those gains and ended the day unchanged against the greenback. The currency still appreciated against the euro and Swiss Franc but the overwhelming demand for dollars erased the GBP/USD's gains. This price action does not downplay the strength of the U.K.'s manufacturing sector. The PMI index rose from 56.5 to 58.4, the highest level in 3 years. New orders also climbed to a record high, which suggests that manufacturing activity in the fourth quarter gained momentum. The employment component of the report also rose strongly. These upside surprises in U.K. data should keep sterling in demand. The BRC retail sales monitor was also due for release Monday night followed by the PMI Construction index on Tuesday. We will look at any pullback in the GBP as an opportunity to buy the currency at lower levels. Since the GBP/USD could be pressured by dollar strength, the best opportunities to trade sterling should be versus the EUR, CHF, AUD and CAD. A trifecta of improvements in PMI could drive the currency to fresh highs as investors re-price their expectations for BoE tightening.

Japanese Yen Crosses Close In On Key Levels
November was a brutal month for the Japanese Yen. The currency weakened across the board, falling more than 6.5% against the British pound, over 4% against the euro and Swiss Franc and 3.8% against the U.S. dollar. Unfortunately on the first trading day of December, the selling continued. The Yen depreciated across the board and this weakness drove USD/JPY to its highest level in 6 months, GBP/JPY to its highest in 5 years and CHF/JPY to a more than 2-decade high. USD/JPY cleared 103 but so far its gains beyond this level is limited. With no U.S. data on the calendar Tuesday, risk appetite will determine if the pair extends higher. Monday's moves were driven by the combination of stronger risk appetite, positive U.S. data and weaker Japanese data. In Japan, capital spending grew only 1.5% in the third quarter, less than half of what economists had anticipated and this means that third quarter GDP due later this week could be revised lower. According to the initial release, the economy grew 0.5% in Q3, down from 0.9% in the second quarter. Thankfully the outlook for Q4 and Q1 of 2014 is bright which should minimize the negative impact on the Nikkei. This is important for the Yen crosses because USD/JPY has a strong correlation with Japanese equities. Labor Cash earnings were due for release Monday night, though it was not expected to have a significant impact on the Yen.

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