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Did the Fed Carve a Bottom for the Dollar?

The U.S. dollar soared against all of the major currencies after the Federal Reserve effectively green lighted a rally for the dollar by growing more optimistic about the outlook for the U.S. economy and saying point blank that they may moderate asset purchases this year and end them completely by mid 2014.

Going into the Fed meeting we were looking for more clarity on the timing of changes in asset purchases and Bernanke couldn’t be more specific.  The Fed Chairman started his press conference by discussing all the reasons why investors should not expect a rate hike and now we understand that he was trying to manage the market’s expectations for the words that followed.  After saying meeting their inflation or unemployment targets does not automatically lead to a rate hike, Bernanke started to talk specifically about their plans to taper.  Investors got a hint of the Fed’s potential aggressiveness from the FOMC statement.  While the central bank cut their GDP forecasts and one Fed President (Bullard) voted for looser monetary policy, the majority felt that the downside risks diminished since the fall and the labor market improved.  In fact the central bank even dropped its forecast for the unemployment rate, kicking off a rally in the dollar that gained momentum after Bernanke said the Fed plans to reduce asset purchases in 2013.

So the question now is whether the clarity in Fed policy has created a bottom for the U.S. dollar and we believe that it has. While the Federal Reserve has gone out of its way to say that tapering does not equal tightening, by reducing asset purchased and announcing their plans to stop buying completely, they have the exit clearly marked.  If we contrast that with what other central banks are doing (the BoJ is in the midst of a major QE program, the ECB is talking about negative deposit rates, the RBA is talking about easing again and the BoE is keeping their options open), the Federal Reserve’s monetary policy bias is extremely positive for the U.S. dollar.  Also given that the central bank intends to end Quantitative Easing as early as mid next year, we can’t expect them to go from full on in December to nothing in June. The central bank will want to reduce asset purchases gradually and give themselves as much as possible to see how the market responds. We have called for Fed tapering in September and continue to believe that this is the right timing. Shifts in monetary policy expectations led to the aggressive sell-off in the U.S. dollar late May, early June and adjustments in expectations could once again change the trend for the dollar.  U.S. 10 year bond yields have spiked in reaction to the FOMC and this rise will only make U.S. fixed income assets even more attractive to foreign investors. In a nutshell, we believe that the dollar has bottomed and if we are looking at levels that means the Dollar Index could rise back to 83, USD/JPY to 100 and the EUR/USD to 1.31.  Tomorrow’s Philly Fed, existing home sales and leading indicators report will take a backseat to post FOMC position adjustments.

EUR – Lifted by Stronger Investor Confidence

The euro fell sharply against the U.S. dollar today after the Federal Reserve laid out plans to change monetary policy over the next 12 months. The last we heard from the European Central Bank, they grew slightly less pessimistic about the outlook for the Eurozone economy but reminded the market that negative deposit rates is still on the table. It is for this reason that the euro performed poorly against the dollar but in contrast to some of the other pairs, the sell-off in the EUR/USD is modest.  Eurozone PMI numbers are scheduled for release tomorrow and these are the most important pieces of economic data expected from the region this week.  If the data surprises to the upside, speculation about negative interest rates will recede and the euro could recover some of its losses.  If the European Central Bank has reason to drop their dovish bias, then the euro could find support but the outperformance will most likely be against other currencies beyond the U.S. dollar.  If the data is weak, the euro could accelerate its losses and catch up to some of the moves experienced by pairs such as the AUD and NZD.

GBP – No Surprises in BoE Minutes

The British pound weakened against the EUR and U.S. dollar as the Bank of England minutes provided very little fresh insight into U.K. monetary policy. According to the minutes, Bank of England Governor Mervyn King once again voted in favor of additional quantitative easing at his last policy meeting. In the past few months King, Paul Fisher and David Miles have all called for boosting stimulus by 25 billion pounds but were out voted by their peers who opted to keep policy unchanged. “For most members, the current policy setting was appropriate at this time,” but King and the minority said the case for more stimulus was credible. The minority said, “Projections implied only a modest recovery in growth and relatively little improvement in unemployment.” The nine-member Monetary Policy Committee unanimously decided to maintain the record low 0.50% interest rate and most said that additional purchases could lead to unwarranted narrowing in risk premiums and complicate further endeavors when the BoE sought to transition into “normal” monetary policy. The effects of the Committee’s previous rounds of asset purchases were still in play and along with the Funding for Lending Scheme should continue to bolster activity. Policy makers said inflation would “more likely than not” rise to around 3% temporarily during the third quarter. “Overall, the committee judged that recent news was consistent with a slow but sustained recovery in growth over 2013.”  In his final speech on the economy today, King said the country needed more stimulus because the recovery was not assured.  U.K. retail sales are scheduled for release tomorrow and we are looking for an upside surprise that could help to stem some of the losses in sterling. Having broken below 1.56 and 1.55, the trend in the GBP/USD appears to have turned but whether these losses are sustained will hinge in part on the outcome of Thursday’s retail sales report.

AUD Hits 2.5 Year Low

Of all the major currencies the Australian and New Zealand dollars were hit the hardest by the U.S. dollar rally and for good reasons because the RBA is thinking about increasing monetary stimulus at a time when the Federal Reserve is preparing to reduce it.  As such, the AUD/USD dropped to a fresh 2.5 year low and appears poised to test the 38.2% Fibonacci retracement of the 2008 to 2011 rally at approximately 0.9160. Despite the RBA’s concerns, a report released by Westpac showed that leading indicators of Australian economic activity continued to signal above-trend growth in the coming quarters. Westpac Senior Economist Matthew Hassan said, “After a slight moderation in March, the Leading Index picked up again in April. However, we remain concerned that this above trend pace will not be sustained over the course of 2013.” The report said the two main factors that contributed to the 0.6% increase in the leading index were real corporate profit and productivity. A survey conducted by the Conference Board yielded similar results.  According to Conference Board, money supply and stock prices made the largest contributions to the index, which rose 0.3% in April. These data improvements may provide hope for the Australian economy but unfortunately these reports are for May and therefore dated. The same is true of New Zealand’s current account balance.  While the country’s deficit reached its best level in 2 years during the first quarter, a large part of the improvement could have evaporated after the sharp decline in the A$ during the second quarter.  New Zealand’s first quarter GDP numbers are due for release this afternoon and while the trade balance improved, slower retail sales growth has economists calling for a weaker release.  A modest rise in Canadian wholesale sales failed to have a significant impact on the loonie.  Yet Bank of Canada Governor Poloz sounded relatively optimistic in his comments today.  He said exports and company spending should lead Canadian growth and while global demand is still the biggest risk for Canada, the U.S. economy has improved.  The 2% inflation target is “sacrosanct” and “there’s plenty of stimulus in Canada’s economy.”

JPY – No Sign of Concern from Kuroda

The Japanese Yen fell aggressively against the U.S. dollar but was mixed against other currencies as the U.S. dollar rally led to sell-offs of varying magnitudes for the major currencies. As we anticipated, the recent strength of the Japanese Yen has taken a toll on trade activity.  The country’s trade deficit widened in the month of May as exports edged lower month over month.  Japan is a country that relies heavily on trade activity and the fact that they have a deficit at all is bad news for Japan.  However while real exports dropped 0.5% m/m, on an annualized basis, export growth increased from 3.8% to 10.1%, so the overall trend of export demand is still higher.  For this reason, the Bank of Japan won’t be overly concerned with the latest numbers particularly since department store sales increased strongly in May, a sign that consumer spending is recovering. Meanwhile in a semiannual hearing in Parliament today, Bank of Japan Governor Haruhiko Kuroda said “Given that Japan’s economy is on a steady path toward recovery, however, they are expected to gradually regain stability, reflecting positive momentum in economic activity.” He also said that the BOJ could add to its monetary easing if the economy were to change drastically.  In his words, “The policy we decided on April 4, we are not saying that we will not change it for two years, and if the economic or financial situation change significantly, and what we decided on April 4 was insufficient or was too much, we would adjust up or down.”  While the rise in some market indicators of inflation expectations has come to a pause, Kuroda felt that other indicators including the surveys conducted on households and economists have been promising.  At the end of the day, the BOJ will examine both upside and downside risks to economic activity and prices, and make adjustments as appropriate.  The Ministry of Finance’s weekly portfolio flow report is scheduled for release this evening.  We will continue to watch these numbers closely to see if Japanese investors have become net buyers of foreign bonds.

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