Dollar Recovers

The US dollar is well bid.  There are two overall drivers.  First, it has been indicated that President Obama will nominate Janet Yellen to lead the Federal Reserve.  This helped lift some uncertainty in the market, though generally speaking, it was well discussed and anticipated by investors, especially since Summer recused himself.  Second, an exit strategy from the fiscal impasse appears to be in the works and has helped dial down the anxiety over a possible default, which most investors did not think likely.    The US Dollar Index is trading at new highs for the month.  

A shockingly poor UK industrial production, once again highlighting the divergence between survey data (PMI) and real sector data, has seen sterling shed over a cent to fall back below  $1.60 for the first time since September 24.  A break of the $1.5950 level could potentially be important from a technical point of view.  It appears to be the neckline of a head and shoulders pattern, which if confirmed, would give potential toward $1.5650.   The initial retracement objective of sterling's rally since mid-July comes just above $1.5700. 

Industrial production in the UK fell 1.1% in August.  The market had expected a 0.4% increase.  Manufacturing slumped 1.2%.  The year-over-year returns into the red at -0.2% from 1.0% in July.  Adding insult to injury, the UK reported a larger than expected trade deficit (GBP9.6 bln vs consensus GBP9.0 bln).    

In contrast, and after the disappointing orders data yesterday, Germany reported stronger than expected industrial output figures.  The 1.4% increase compares with the consensus forecast of 1.0% and the July data was revised to show a more modest 1.1% decline instead of the initially 1.7% drop.  The euro showed little reaction to the news. 

The US dollar took on a bid in response to the reports indicating that  Yellen would get the nomination.  Some may find it ironic, as she is seen to be a dove at the Fed.  However, the important take away is that it reduces some lingering uncertainty.  While the opposition to Summers came primarily from within the Democrat Party, opposition to Yellen is likely to be emanate from some Republicans who see her has too vested in QE and is, indirectly, a third term for Bernanke.  We suspect that Yellen's stance is more nuanced and, in different economic conditions, her views will change.   Reviewing her public record, the one characteristic that seems clear is independent thinking and a gradualist.  

One twist here that many are not contemplating, is that Bernanke should be expected to resign as soon as reasonable after Yellen is confirmed.  It serves no one's interest to have to chairpersons, even though the transition with Yellen will be smoother than with any other candidate.   Given the pace at which Congress moves, it is possible, under this scenario that Bernanke's last meeting is the mid-Dec one and Yellen's first is the end of January 2014. 

While the Federal government remains partially shut, the politicians appear to be edging toward a compromise.  The compromise is not really over substance, but rather procedures.  A short-term clean continuing resolution and lift to the debt ceiling that would allow more time to negotiate.   Defining "short-term" may be a good litmus test.  Many Republicans will likely seek a shorter period, while Democrats may favor a longer period.  

The US budget deficit is falling faster than nearly any one expected, which is why the size of the 3-year note sale was the smallest such offering since January 2009 and the second consecutive reduction in size.  Yet we have warned that a budget compromise is likely to entail for spending cuts, which in turn add to the fiscal drag.  We had seen this in the context of why we expected the Fed's to disappoint with the tapering in September and one of the reasons why we think tapering is more likely to begin next year rather than this year. 

The US Treasury sells 10-year notes today.  The yesterday's 3-year note sale results were soft, with the bid-cover coming in below the recent averages (though still three-fold oversubscribed).  Although there is some concern that the political drama and fear of default would hasten the diversification out of dollars by central bankers and sovereign wealth funds, the indirect participants at yesterday's auction, which includes central banks, increased their take to 34.4% from 33.1% at last month's auction and up from a little more than 28% average over the past ten such auctions.    

After the markets close, the Federal Reserve will report its custody holdings for foreign central banks and official accounts.   After falling about $50 bln from mid-June through the end of July, largely we suspect as several emerging market countries intervened to slow their currencies' descent and smooth the outflow for portfolio capital, the Fed's custody holdings have risen steadily, rebuilding about half of the draw down.  There can be some volatility in the week-to-week results, but we expect central banks to continue to rebuild.   The shenanigans in Washington may make some holders wish more strongly that there was a clear and viable alternative to the US Treasury market.  There is not for the largest pools of capital. 

The market may not wait for an official compromise to emerge from Washington, but will begin adjusting positions accordingly.  Initial euro support is seen near $1.35, but it may take a break of the $1.3450 area to confirm a top.    Although yesterday's close in the dollar-yen was not inspiring, the fact that there has been some follow through today and that it continues to hold above the 200-day moving average, which was frayed yesterday, also bodes well technically.  A move above JPY97.50 may open the door to another yen rise toward JPY98.50.