Why Dollar Rally Is The Real Deal

With U.S. stocks climbing to new record breaking levels and 10 year Treasury yields inching towards 2%, the U.S. dollar powered to fresh highs against all major currencies. For the first time in over a month, the EUR/USD closed below 1.2950 and demand for USD/JPY drove the pair to its highest level in 4.5 years. Traditionally, a rally in equities is positive for risk currencies but in this case, the EUR, AUD, GBP and NZD, which normally track stocks higher have not participated in the rally. In fact, they have gone in the completely opposite directions. Instead the rally in the U.S. dollar, rise in U.S. yields and sustained gains in U.S. equities tells us that this is a story about the attractiveness of American assets. In other words, the rally in the U.S. dollar is the real deal because it is confirmed by the movement of other markets, the bias of the central bank and economic data. The greenback had a delayed reaction to Monday's better than expected U.S. retail sales report but the pause has now given way to further gains. Given that the Federal Reserve had been talking about tapering asset purchases since the beginning of the year, we are not surprised if there is merit to the Wall Street Journal's claim that a plan has is mapped out. Now that the economy is improving, central banks need to start thinking about ways to reduce stimulus and even start to outline an exit strategy. So for better or worst, the WSJ is stating the obvious because it is part of the central bank's job to plan ahead and to come up with various alternatives even if they are not ready to pull the trigger immediately. It won't happen before September but the mere fact that the U.S. central bank is thinking about reducing accommodation puts them in a very different position from the ECB, BoJ and RBA and this alone is enough justification for a sustainable dollar rally. If any of these central banks shift from a dovish to a neutral monetary policy stance, it would threaten the dollar's rally but we do not expect that to happen anytime soon. Today is a busy day for U.S. data with the Empire State, industrial production, producer prices and Treasury International Capital flow report scheduled for release. Of these reports the manufacturing numbers will be the most important as they are activity readings that provide further information on how the U.S. economy is performing.

EUR Breaks 1.2950, GDP Will Determine If Losses Last
The EUR/USD finally broke below 1.2950 and to our disappointment the sell-off did not gain momentum quickly. Instead, the currency quietly dripped lower to end the day at its lows. Economic data continues to be weak with the German ZEW survey holding steady at 36.4. Economists expected the ECB rate cut and the rise in equities to boost investor confidence but it failed to do the trick as investors grew more concerned about current conditions. To their credit, they were more optimistic about future conditions but clearly that was not enough to prevent further losses in the euro. The same was true of Eurozone industrial production, which rose 1% in the month of March. Euro-zone GDP numbers are scheduled for release Wednesday and while the German economy is expected to return to growth, the euro zone as a whole should have remained in recession in the first quarter. If GDP growth for region is negative, it would mark the sixth consecutive quarter of contraction. Considering that we are also looking for stronger German growth in the first three months of the year because retail sales and trade activity improved, there's room an upside surprise in the regional index. If GDP growth surprises to the upside, the EUR/USD could hold 1.29 but if it disappoints like the ZEW survey, the currency pair could slip down to support at 1.28.

New 4-Year Highs for USD/JPY
The U.S. dollar hit fresh 4.5 year highs against the Japanese Yen Wednesday. Initially the USD/JPY rally had appeared to stall but once Treasury yields turned positive USD/JPY broke above 102 to hit an intraday high of 102.43. At this point, there is no major resistance in USD/JPY until 103.25, the 38.2% Fibonacci retracement of the 1998 to 2011 sell-off. Overnight, 10-year JGB yields jumped 11bp, which was huge for Japan since their bonds yield only 0.85% and this move raised concerns that domestic investors may choose to keep their funds in Japan. However with U.S. yields inching towards 2%, there are better opportunities elsewhere. Japanese investors will realize that BoJ policies are aimed at keeping the Yen weak while the Fed is preparing to remove stimulus, which could boost the value of the greenback, creating an opportunity for yield and capital appreciation.

GBP: Waiting for BoE Quarterly Inflation Report and Employment Numbers
For the fourth consecutive trading day, the British pound extended its losses against the U.S. dollar. There's a lot going on in the U.K. tomorrow with the Bank of England's Quarterly Inflation report and the country's employment numbers due for release. Based on recent improvements in economic data, the central bank could grow slightly more optimistic but we do not expect any changes to their GDP or inflation forecasts as the decline in commodity prices in the month of March was erased in April. While the recent strength in the U.S. dollar put a lid on the commodity rally, prices are still relatively high which could discourage the central bank from altering their forecasts. The RICS house price index increased less than expected which may have contributed to sterling's weakness against the USD and EUR. The employment numbers will be released before the Quarterly Inflation Report and the improvement in service, manufacturing and construction sector activity suggests that we could see a larger decline in jobless claims, which would be positive for the GBP.

AUD/USD Drops Below 99 Cents
The Australian, New Zealand and Canadian dollars fell sharply against the greenback on the heels of lower commodity prices and broad dollar strength. The AUD/USD dropped below 99 cents, adding to a move that has now shaved approximately 6% off the currency pair's value since April 11th. Over this same time period, the New Zealand dollar lost more than 5% of its value. At a time when stocks are performing well, the weakness of the commodity currencies is a strong sign that country specific performance and broad U.S. dollar strength are the driving forces in the FX market right now. There is no major support in the AUD/USD until 98 cents. Of all the major currencies, the New Zealand dollar was the worst performer courtesy of weaker than expected retail sales growth in the first quarter. Consumer spending growth slowed to 0.5% in Q1 from 1.9% in Q4. Losses in the CAD were also severe but can only be partially attributed to slower house price growth. Canadian manufacturing sales and Australian wage cost numbers are scheduled for release this evening. These secondary economic reports are not expected to threaten the downtrend in the AUD and NZD.

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