Euro, Canadian Dollar, Swedish Krona, Yen

The euro has broken above the $1.2350-$1.2400 band of resistance that has capped the corrective upticks in recent days. If this is sustained, we have suggested there is potential in the coming sessions toward $1.2600.

Our constructive outlook for the dollar was never based solely on Europe’s woes, though of course that has been the dominant factor. The other support for the greenback comes form favorable economic developments in the US. Our hypothesis has been that macro-economic fundamentals will replace the “risk-on/risk-off” matrix. We have focused on the output gap, and the countries that can close it first should have stronger currencies.

Even after the disappointing downward revision to Q1 US GDP, growth was still above trend and it will likely be again this quarter. Recall that the Federal Reserve revised up its forecast for US growth recently to 3.2-3.7% this year and 3.4-3.5% next year. The US output gap is closing, albeit slowly, while Europe’s is still widening. The reason this is particularly relevant now is that just because the poor news stream out of Europe may slacken, it does not mean the euro’s decline is over. After the UK and US holidays at the start of next week, the market will increasingly turn its attention to the US jobs report at the end of the week. The Bloomberg consensus is for a 500k increase in non-farm payrolls, of which more than 200k will be in the private sector.

The Canadian dollar and Swedish krona are advancing today for macro-economic considerations too. The Bank of Canada is expected to be the first G7 central bank to lift key rates. It meets on June 1 and a Reuters poll of Canada’s 12 primary dealers finds unanimity in expectations that the central bank hikes 25 bp not on Tuesday next week but also again at the July 20th meeting. All but one looks for a hike at the early Sept meeting too. Higher commodity prices, rate hike expectations and calmer capital markets can see the Canadian dollar continue to recover. While the US dollar has support near CAD1.04, there is potential toward CAD1.0250 in the next week or so.

Sweden’s Riksbank has been preparing the market for a July rate hike, but the EU turmoil gave the market second thoughts. However, today Sweden reported a much stronger than expected Q! GDP of 1.4% (consensus was for less than 1%), but just as important is the fact that Q4 09 GDP was revised to +0.4% from the initially reported -0.6%. This would seem to put the July hike back into play, even though the April retail sales report was disappointing (-0.2% vs consensus +0.5%). As we have seen in many countries the early Easter distorted the March/April retail sales. Look for krona to continue its recovery against the euro, with last week’s euro low of SEK9.5250 area being a reasonable near-term target.

Japan reported a how of data, but the yen remains largely sidelined. Over the past month, as the European crisis flared, the yen’s correlation with equity prices increased and its correlation with interest rate differentials seemed to slacken. As the panic ebbs, interest rate differentials are likely to become a more important driver.

Although capital expenditures and exports are fueling stronger growth than many, including us, expected, it is not sufficient to address what ails the Japanese economy. News today includes the second consecutive monthly increase in the unemployment rate, now 5.1% and some deterioration in the jobs-to-applicant ration, which is the first decline in eight months. April household spending completely unwound the impressive 5.9% gain in March by dropping 6.3%. This puts in back into the red on a year-over-year basis. This volatility reflects the removal of government incentives.

Last, but by no means least is the strengthening of deflationary forces. April CPI fell 1.2% year-over-year, compared with 1.1% decline in March. Excluding fuel and food, prices fell a record 1.6% yoy compared with 1.1% in March. This deterioration reflects the abolition of high school fees (worth about 0.55 percentage points). The more current Tokyo CPI reading for May shows deflationary forces may be slightly moderating.

The JPY91.50 area corresponds to a 50% retracement of the dollar’s decline this month. This month’s range was set on two days—May 5-6, when the dollar fell from almost JPY95 to just below JPY88. There is potential in the coming days for the dollar to rise into the JPY92.00-50 area.