What To Make Of The Dollar's Fractured Performance

There was very little consistency in the performance of the greenback Thursday with the dollar strengthening significantly against the Japanese Yen, Australian, New Zealand and Canadian dollars and weakening slightly against the euro, British pound and Swiss Franc. The dollar's fractured performance along with the strong recovery in U.S. stocks and decline in Treasury yields tell us that investors are less worried about the Federal Reserve tapering in December. Perhaps it was the Senate Banking Committee's approval of Janet Yellen's Fed Chief nomination that made investors optimistic but either way, the market is finally waking up to the notion that the odds still favoring tapering in 2014 versus 2013. The next step for Yellen would be to win the approval of the full Senate who will most likely vote on her nomination in December. Once again, she is expected to win their approval easily, paving the way for the first female Federal Reserve Chairman.

The fractured performance of the dollar Thursday is also consistent with mixed U.S. economic reports. While weekly jobless claims dropped to its lowest level since September, producer prices declined for the second month in a row and the Philadelphia Fed manufacturing index retreated. Fewer jobless claims is good for the labor market but by now investors know that fewer job losses does not always translate into greater job growth. Producer prices dropped 0.2% in October, leaving the year over year rate unchanged at 0.3% Excluding food and energy costs, prices increased by 0.2%, but as Yellen said in her testimony before the Senate Banking Committee, inflationary pressures in the U.S. are very low. The primary fear of the central bankers calling for earlier tapering is inflation and so far we have not seen any major evidence of that. Instead, manufacturing activity continues to disappoint with the Philly Fed index dropping to 6.5 from 19.8. This weakness follows a similar decline in the Empire State survey and suggests that the recovery could be losing momentum. With no U.S. economic reports on the calendar Friday, the outlook for the dollar will hinge on risk appetite.

EUR Recovers After Draghi Downplays Talk Of Negative Rates
The euro rebounded against the U.S. dollar after ECB President Draghi downplayed the buzz about negative rates. While we have heard a number of European policymakers including Asmussen who spoke after Draghi, say that negative rates is an option that the central bank is technically ready to use, Draghi doesn't want the speculation to get out of hand. The bar for negative rates is high and as Asmussen said, they "would be very cautious to use negative deposit rates" as a tool to ensure stable prices. ECB President Draghi warned investors against inferring too much from the negative deposit rate talk because there has been no news since the last meeting. He made it clear that low inflation was their motivation for the recent rate cut because the central bank did not want to let deflation become a risk. However the high unemployment rate and their view that the recovery is weak, uneven and fragile suggests that sluggish growth also played a role in their decision. In fact Draghi's pessimistic view on the outlook for the economy indicates that the central bank still maintains a dovish bias and will be willing to ease further if growth does not accelerate. According to the latest PMI reports, euro zone economic activity grew at a slower pace in the month of November. The details showed a stronger expansion in Germany but a deeper contraction in France. As indicated by our colleague Boris Schlossberg, "this massive imbalance between Germany and the rest of Europe could create very serious tensions with the ECB, especially if Germans resist any further attempts to expand monetary policy." Looking ahead, the German IFO report is scheduled for release and based on the rise in the country's PMIs reports we expect stronger business confidence in the month of November.

AUD: RBA Steps Up Verbal Intervention By Threating Physical Action
The Australian and New Zealand dollars extended their losses against the greenback Thursday on the heels of slower growth in China's manufacturing sector, lower commodity prices and talk of intervention by the Reserve Bank of Australia. The commodity currencies had been supported by stronger growth in China during the third quarter but according to HSBC's flash PMI index, the manufacturing sector is beginning to lose momentum. While this may only be a preliminary gage (the official release comes later), it reinforces some of the market's concerns that growth is moderating in the world's second largest economy. The country's reform measures also pose a downside risk to growth going forward because reforms can be costly. However any slowdown in China's economy is likely to be gradual. Instead the RBA's discomfort with the high level of the A$ is the greater risk for the currency. The central bank has been struggling to promote growth and believes that a weaker currency is essential to a stronger recovery. They stepped up verbal intervention last night by reminding the market that their "position has long been, and remains, that foreign exchange intervention can, judiciously used in the right circumstances, be effective and useful....it remains part of the toolkit." While this does not necessarily mean they are ready to pull the trigger and sell A$, it confirms that they lean towards easier monetary policy and are willing to expand the tools that they have been using to stimulate the economy. The last time the RBA intervened in the A$ was in 2008 during the financial crisis. While their efforts eventually paid off, their initial efforts did not always last and it took nine days of intervention before the A$ finally stabilized. Meanwhile gold prices dropped to its lowest level since July, adding pressure on the AUD/USD. We expect both the AUD and NZD to remain under pressure but NZD should outperform, leading to a further slide in AUD/NZD. This afternoon RBNZ Assistant Governor McDermott will talk about the New Zealand dollar and they are likely to share the RBA's concerns about a high currency although they are less inclined to intervene. Canada's consumer price and retail sales report are scheduled for release Friday. The currency pair has finally broken 1.05 in a meaningful way and a downside surprise in retail sales would solidify the breakout.

USD/JPY To 105?
With the Nikkei up 1.92% overnight and U.S. yields holding onto recent gains, the dollar hit its highest level against the Japanese Yen in 4 months. All of the Yen crosses benefitted from this move but EUR/JPY in particular rose to a fresh 4 year high, GBP/JPY to a 5 year high and CHF/JPY to 23 year high. For USD/JPY, 100 is now in the rearview mirror. From a fundamental perspective, we have long said that U.S. rates are headed higher and as long as this remains true, USD/JPY will rise. Regardless of whether the central bank chooses to reduce asset purchases in December, January or March, there is no question that they will start paring stimulus within the next 4 months. More importantly, when they announce their plan to reduce monthly bond purchases, it may include a schedule to bring asset purchases to zero. Last year Bernanke said Quantitative Easing will end in 2014 and given the urgency heard in the voices of some policymakers who vote next year, we believe they will stick to this timeline. This means the dollar will not only receive support from a tapering itself but also the prospect of QE ending. By mid 2014, we expect 10-year Treasury yields comfortably above 3% and closer to 3.5%, which would be consistent with 105 in USD/JPY. Of course, this does not remove the possibility of a retracement before this level is reached especially if investors need to adjust their expectations for tapering in 2014 instead of 2013. With monetary policy in Japan expected to support equities throughout the next year, further gains in the Nikkei should also promote a stronger rally in USD/JPY. As we have seen in the most recent trade numbers from Japan, imports are rising because of the recovery and this trend is expected to continue. More foreign imports by the Japanese means more Yen outflows. The rise in U.S. yields in 2014 should also accelerate foreign investment by Japanese retail and institutional investors. In fact, retail investors became net buyers of Uridashi bonds (foreign bonds) in October for the first time since November 2012. The most significant risk for Japan however is the consumption tax hike. If spending contracts significantly, the Nikkei could reverse its rise but the Bank of Japan would most likely respond by increasing stimulus. The only problem is that the latest IMM report showed short Yen positions near a seven-year high. Speculative positions have continued to build over the past few weeks with Yen short or long USD/JPY positions at their highest levels since 2007. When we have positions at such extreme levels, the currency pair is very vulnerable to profit taking on any sign of weakness as extreme shorts in IMM positioning are typically followed by a corresponding reversal in USD/JPY.

GBP: Supported By Narrower Budget Deficit
It was a relatively quiet day for the British pound, which ended the North American trading session higher against the U.S. dollar and euro. According to the latest reports on U.K. public finances, the country's deficit narrowed in the month of October ahead of Chancellor Osborne's August Statement. Public sector net borrowing excluding interventions dropped from 10.3B to 8.1 billion last month and while this decline was smaller than anticipated, it was also much less than the Office for Budget Responsibility had forecasted. The improvement was driven by a 46% increase in stamp tax revenues on property sales. This contribution from the housing market provides further evidence that the government's funding for lending schemes continue to support the recovery. The Confederation of British Industry's Industrial Trends report was also released. This survey of the manufacturing sector is one of our favorite leading indicators for U.K. PMI and the latest report shows manufacturing activity rebounding significantly in the month of November. The index rose from -4 to 11, matching the 1995 high. According to the last PMI report for the month of October, manufacturing activity slowed but Thursday's CBI index suggests that the momentum accelerated in November.

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