USD: Investors Are Betting Against The Fed

Dollar: Betting on the Fed Being Wrong?

Based on the recent price action of currencies, equities and Treasuries, investors appear to be betting that the Federal Reserve will be wrong in that interest rates will not rise as quickly as they anticipate. While the central bank has not specified exactly when the first rate hike will be, according to their official forecasts, the main interest rate is expected to reach 1% by the end of 2015. In no way is this an aggressive forecast but investors believe the central bank will be even more cautious as Quantitative Easing draws to close. The market is pricing in only about 50bp of tightening by the end of next year, which explains why even with Tuesday’s mild dollar rally, the greenback’s gains have been limited. The weakness of Treasury yields and rise in U.S. stocks reinforce our view that the market is not only betting on the Fed being wrong but also banking on a slower pace of tightening. With the central bank gradually drawing its Quantitative Easing program to a close, U.S. yields should be trading at much higher levels but slow growth and low inflation has led many investors to believe that the central bank won’t be raising interest rates anytime soon. In fact if growth and inflation does not start to rise by the time QE ends, the central bank could opt to reinvest proceeds from maturing Treasuries and mortgage bonds to insure the recovery. These expectations also explain why the dollar’s reaction to stronger data has been so benign. The greenback ticked only slightly higher Tuesday versus G3 currencies despite a surprise increase in durable goods, rise in house prices, acceleration in service sector activity and improvement in consumer confidence. In fact, bond investors were not impressed as prices increased and yields continued to fall. A lot of U.S. data was released Tuesday and their positive reads were encouraging but ultimately, the impact of the markets will be limited because they won’t make the central bank any more eager to increase interest rates.

EUR Drifts Lower as ECB Continues to Talk Easing

The euro continued to drift lower ahead of next week’s European Central Bank meeting. Over the holiday weekend, ECB President Draghi suggested that Quantitative Easing could become a reality for the Eurozone. He said destabilizing of inflation expectations “would be the context for a broad-based asset purchase program.” Draghi believes that the risk of deflationary expectations is taking hold and the central bank will not allow inflation to remain overly low for too long. However even if the odds of QE have increased, the central bank is not ready to introduce this program next week. In fact, Draghi said this morning that they will do everything feasible “within their mandate” to get inflation to target. While there are ways to pursue QE within the central bank’s mandate, there are a number of technical issues the biggest of which are the legal and political obstacles of buying European sovereign bonds. So in the meantime, the central bank will stick to conventional options. Based on all of recent comments from Eurozone officials, there’s no question that the ECB will ease next week and there’s a good chance they will go all out by cutting the refi rate, lowering the deposit rate to negative levels, end SMP sterilization and deploy another long term refinancing operation (LTRO). How far these actions drive the euro will depend on the central bank’s guidance. If they suggest that more steps could be taken if inflation does not rise, the euro will experience deeper losses. If they shift back to neutral, the losses will be limited. We have been looking for EUR/USD to drift to 1.3600 ahead of the rate decision and now that the currency pair is within arms reach of that level, we are extending our projections for the possible decline to 1.3550. Although EUR/USD remains weak, it could bounce on the back of Wednesday’s German labor market report. Based on the PMIs, private sector employment increased significantly in the month of May, which puts the odds in favor of a stronger release.

GBP Loses Out on Failed Pfizer / AstraZeneca Deal

The British pound traded slightly lower against all of the major currencies Tuesday on the back of weaker housing market data. A total of 42,173 mortgages were approved in the month of April, down from 45,045 the previous month. While it is not clear whether this decline was driven by elevated house prices or tighter lending rules introduced last month that required borrowers to meet more stringent affordability tests, the fact of the matter is that mortgage approvals dropped to 8 month lows, a sign that the housing market is slowing. Considering that the only part of the economy with inflation is housing, the Bank of England will be happy to see activity cooling. In a very small way, this also reinforces the central bank’s decision to keep monetary policy steady. Pfizer’s decision to ditch its pursuit of Astrazeneca (NYSE:AZN) also weighed on sterling because the deal would have been worth $117 billion. The cash and stock deal could have created significant short-term demand for the British pound. EUR/GBP is finding significant support at its 1-year low of 0.8080 and with no major U.K. economic reports on the calendar this week, Eurozone data will determine whether this level becomes a bottom – we believe that further losses are likely ahead of next week’s ECB meeting.

AUD Erases Gains as Gold Breaks Down

Given the sharp decline in the price of Gold Tuesday, the movement in the Australian dollar has been relatively benign because the same dynamic that drove gold lower kept AUD well supported – new highs in U.S. stocks bolstered risk appetite and reduced the attractiveness of parking funds in the safety of gold. Stops were also triggered in gold when it broke the April low of 1284 and this technically driven selling did not affect the Australian dollar. However if gold prices, which have dropped to a 3-month low continue to fall, the decline will become difficult for the Australian dollar to ignore. Leading indicators were scheduled for release Tuesday evening and based on the trend of recent economic reports the odds were in favor of a decline for the month of April. The New Zealand dollar on the other hand edged lower against the greenback in a delayed reaction to Sunday night’s trade balance. Steep declined in dairy and meat shipments caused the country’s trade surplus to shrink from 935 million to 534 million. Incoming evidence continues to build the case for a pause by the Reserve Bank in June and Tuesday night’s business confidence report should show additional weakness. We expect NZD to drift lower ahead of the June 11th monetary policy decision. Finally the Canadian dollar erased its earlier gains to end the day lower against the greenback. No economic data was released out of Canada but the turnaround in the currency was triggered by the U.S.’ PMI and consumer confidence reports as stronger U.S. data lent support to USD/CAD.

JPY: Risk Appetite vs. BoJ Policy

Over the next few weeks, the big question for the Bank of Japan, Nikkei 225, Japanese Yen and JGB traders is the amount of damage that the consumption tax hike had on the economy. One would naturally assume that after spending strongly in March in the lead up to the April 1 tax hike, demand would retreat aggressively in April and May. This possibility would deter business activity and investment as companies in Japan wait to see how much drag the tax had on the economy. However based on the initial readings, Japanese companies are looking beyond the tax hike and increasing their capital investments. The 19.1% monthly increase in machine orders in March was the largest rise since 1996. In the month of May, manufacturing activity also improved with the PMI index closing in on the neutral 50 level. Last night, we learned that small business confidence also improved this month, which is encouraging because they are the most sensitive to the fluctuations in the economy. Together, these improvements reinforce the Bank of Japan’s confidence in the economy and suggest that the impact of the consumption tax will be limited. While we acknowledge the recent data improvements, we believe it is too early to draw any conclusions about consumption. Yet until there is evidence of weakening demand, the Bank of Japan will remain on hold. With the Government’s Pension Investment Fund increasing its exposure to Japanese stocks and the BoJ committed to maintaining steady policy in the near term, the decline in the Yen should be limited but we all know that Japan’s currency trades primary on the market’s demand for risk and the new record in U.S. stocks is keeping pressure on the yen.

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