The Dollar's Five Keys in the Week Ahead

With the end of Asia's lunar new year celebration and the return of the US and Canadian markets after yesterday's holiday, there is full liquidity in the global capital markets for the first time in over a week.  The currencies are mixed, with the yen, sterling and the Australian dollar posting modest gains, while the euro, Swiss franc and Canadian dollar have heavier tones.

The Chinese yuan has weakened for the second day after returning from the extended holiday and is near 2-month lows.  After reversing lower yesterday, the Shanghai Composite led the regional bourses lower with a 1.9% decline.  The Composite is approaching its 20-day moving average (~2365) which it has not traded below since early December.  European equity markets are higher and the Dow Jones Stoxx 600 is up a little more than 0.5% led by consumer goods and basic materials.  Of the main industrial sectors, only telecom is lower.  European bond markets, core as well as periphery are lower. 

Broadly speaking, we identify five factors that will shape foreign exchange rates in coming days.
 

First is the aftermath of the G2/G20 meetings and statements.  Essentially the rules of engagement has they have evolved since the Plaza and Louvre agreements are that countries should refrain from directly managing their currencies and allow the foreign exchange market to clear the market for goods and capital.  The Japanese government crossed the line, which allows the pursuit of monetary and fiscal policy appropriate for one's domestic economy, but not bilateral exchange rate targets.  The G7/20 statement reiterates the rules of engagement.  Japanese officials seem to have been reminded of the rules privately and over the past couple of weeks or so, have shied away from making such pointed comments about the yen's exchange rate.  Japanese policy makers understood the implication of the push back and earlier today Finance Minister Aso indicated that the government is not considering the purchase of foreign bonds nor a change in the BOJ's charter.  On a separate front, Muto, the apparent front runner for BOJ Governor, is the least dovish of the three main candidates.  A formal announcement is expected after PM Abe returns from his Feb 21-24 visit to the US. 

Second is the latest high frequency data that will be reported.  What stands out are the German sentiment surveys, beginning with today's ZEW, but more importantly the flash PMI and IFO in the second half of the week.  The ZEW measure of expectations surged from 31.5 to 48.2, the highest since April 2010, though the current assessment slipped rather than improve as the consensus expected.  It is generally thought that after the 0.6% contraction in Q4, 12, the German economy is expanding again, even if just barely, here in Q1 13.  France, on the other hand, will report a flash PMI report.  The evidence so far this year suggests the French economy is still contracting.  The UK, whose economy is also struggling, reports employment figures midweek.  Employment in the UK has generally held up better than in many other countries.  The US reports both inflation gauges and existing and housing starts and new home sales.  It is generally understood by investors that measured inflation is low in the US and the housing market is in a saw tooth slow recovery.  

Third are the FOMC minutes.  There is much anticipation that the Fed began to discuss how to exit from QE.   The FOMC minutes are not a full transcript of the meeting, of course, but rather is a tailored narrative that is also used (not just by the Fed) as part of its signaling and communication tools.  Given that the Fed announced the more than doubling of its outright long-term asset purchases in December, we think that it is far too early to take seriously exit talk, except of course in the broadest of terms, as it is always prudent to have well thought out exit strategies.  This is especially true given that the full impact of the payroll saving tax is not fully understood yet and the sequester that could shave around 0.5% (more than most European countries will grow likely grow this year) off US GDP, is looming.  Separately, we note that the RBA minutes were more neutral than dovish and this has helped lift the Australian dollar, which is the best performer today among the major currencies.  The odds of a March rate cut have slipped and are now near a 1 in 4 chance.  Minutes from last month's BOJ meeting were also released.  There were no surprises, but they did drive home the point that the central bank is likely to continue easing under the new leadership. 

Fourth, there are important events in Europe that a concentrated at the end of the week and have potential for greater impact than the economic data.  The EU will provide updated macro economic forecasts.  These will be especially important for France and Spain.  The French government currently forecasts 2013 growth at 0.8%, twice what the EU forecast in July.  Weaker growth means a larger budget deficit.  Spain remains in a fragile state and it needs growth to fend off the wolf that remains just outside the door.  The Rajoy government has indicated that if the EU grants it more time to meet its deficit target, it will grant some additional leeway to the regions.  In addition, at the end of the week, banks will declare, for the first time, how much of the second LTRO they will repay next week.  Many, if not most, expected 150-200 bln euros will be repaid.   An upside surprise would further reduce the accommodative setting of monetary conditions and could see the two-year interest rate differential, which is tracking the euro-dollar exchange rate closely, move more toward Germany and thereby lending the euro greater support.   Finally, on Feb 24-25, Italy goes to the polls for national and regional offices.  The most likely outcome is a center-left victory in the lower chamber and a coalition with the Monti' centrists in the upper chamber.  However, the situation is fluid and the personalities mercurial.  A wide range of outcomes is possible.  

Fifth is the technical condition of the dollar.  At the start of the year it seemed the euro was independently strong.  The yen, sterling and the Australian and Canadian dollars were weak.  In the past couple of weeks, the euro has succumbed to pressure and has pulled back from its brief push above $1.37 at the start of the month.  The US dollar is showing resilience in the face of ongoing QE and end of the payroll tax holiday and the pending sequester.  The Dollar-Index, to illustrate the point, has now closed above the downtrend line going back to mid-November since the middle of last week.  It intersects today near 80.30.