Strong Finish to Week for US Dollar

The US dollar is capping this week's strong performance with new gains and the Dollar Index is at new highs for the year.  It was the dollar-bloc currencies that had the dubious honor of being the weakest currencies over the past week, taking the baton from the Japanese yen.  

Although the US reported some soft economic data in recent days, including a backing up of weekly initial jobless claims, the second consecutive monthly decline in manufacturing output and softer than expected consumer prices, the market is going through one of its episodic periods where it flirts with the possibility that the QE, which some had disparaged for being infinite, might end earlier than previously anticipated. 

The combination of comments by two Fed presidents, Plosser and Williams, and resilience of the labor market have fanned expectations that the FOMC could taper QE purchases around mid-year. This heightened expectation is crystallizing as European officials continue talk about the possibility of additional easing, including a negative deposit rate.  Rumors made in the rounds in Europe today that at least one major bank was contacted by the ECB about preparations for a negative deposit rate. 

We suspect the market is getting ahead of itself.  Neither Plosser nor Williams are voting members of the FOMC.  Williams is closer to the Fed's Troika of Bernanke, Yellen (who he replaced as the San Fran Fed President) and Dudley, but his remarks were conditioned on continued improvement.  

Given what Bernanke called the "reach for yield" in a speech at the end of last week, it makes sense that the Fed officials address investor concerns that the QE is creating bubble of its own, or in Fed-speak, encouraging a level of risk-taking not justified by fundamental conditions.  Indicating that QE is not infinite after all and that asset markets are being watched closely is one way deflect criticism.   In this context, Bernanke's testimony on the economy in the middle of next week is more important than Plosser and Williams comments.  

Moreover, the softness of inflation readings may be more important for Fed policy than the labor market in the coming months.  What we mean by that is the decline in measured inflation gives the Fed more time to push for faster job creation. 

Headline CPI, which in April was 1.1% above year ago levels, has a difficult comparison with a year ago.  In May-July 2012, the month-over-month CPI changes were net-net flat.  This suggest headline CPI may stabilize in the coming months.  However, the 0.5% increase in both August and September will drop out and the risk is that headline CPI falls below 1%.  Core CPI has been a bit stickier, it peaked a year ago at 2.3% and in April stood at 1.7%.  Given base effects, it is likely to slip below 1.5% in the coming months.  

Separately, we note that broad US money growth seems largely unaffected by the $85 bln purchases the Fed is making every month.   M1, which is most impacted by QE has slowed to a 11.9% year-over-year pace in April from 13.2% pace at the end of last year.  M2 has slowed from an 8.0% clip in December '12 to 7.1% in April.  Bank loans rose 3.7% above a year ago.  Last year they rose 4.2%.  

US 2 and 10-year yields were largely flat over the past week.  Japanese yields were higher and it is both the rise and volatility of the JGB market that will likely dominate the discussion when the BOJ meets early next week.  Given the recent economic data, which includes the stronger than expected GDP and the 14.2% increase in March machinery orders (reported earlier today after the GDP figures shows that capital spending fell for the fifth consecutive quarter), there is some risk that the BOJ (and the Abe government) upgrade their economic assessment, even though the GDP deflator showed the most deflation in over a year.  European and Australian/New Zealand interest rates were lower, with the UK, the notable exception.  

With the G7 offering little resistance to yen weakness, the small rise in Japanese rates make little difference and many players are looking for JPY105 in the coming weeks.  The yen is not match for the dollar currently, but it is for the euro.  The euro-yen is little changed on the week   The poor euro area growth, softening inflation, the increased risk of easier monetary policy (and potentially disruptive if the deposit rate is cut below zero) haven given the euro bears more fodder.  

The fascination with the dollar-bloc has ended abruptly. Don't fight the central banks seemed like a key mantra for many investors and central banks were diversifying reserves into the dollar-bloc.  The reach for yield favored them as well.  The shortage of triple-A paper also was thought to offer protection especially for the Canadian and Australian dollars.   

Perhaps the question is which central bankers one ought to pay attention to.  Dollar-bloc central bankers themselves often expressed frustration with the strength of their currencies, but investors had largely ignored this in the recent past.   In any event, softness of the Chinese economy, where recent import and export data is viewed with a jaded eye--not just by foreign investors, but by Chinese officials--and the decline in commodity prices, with implications for macro economic performance and investment plans ,have taken a toll.  In particular, it is the pace of the Australian dollar's decline, pushed along by negative comments (which likely means short positions) from some high profile hedge funds, that is spurred the dramatic price action.  

The US dollar is finishing the week firmly for two reasons.  The first is positive developments for the dollar, though we are skeptical of how quick the Fed tapers off its purchases given the subdued price pressures and slow gains in non-farm payrolls.  Bernanke's testimony will be important.  The second is a deterioration of the macro-fundamentals in Europe and the dollar-bloc, with no major objection to continued yen weakness.   Interest rate developments generally are consistent with price action.