Dollar Recovers into the Weekend

It may not be the proverbial, "when hell freezes over", but it is snowing in Cairo, Egypt for the first time in 112 years and in the foreign exchange market, the dollar is enjoying a somewhat less rare event of appreciating against the major and emerging market currencies.  

The dollar's firmer tone, with the euro falling to 4-day lows and sterling to 2-week lows, is likely position squaring ahead of next week's FOMC meeting, the last major event of the year.  As we noted yesterday, the euro and sterling's upside momentum, left the currencies vulnerable after their recent run.  

The strength of US retail sales and the continued inventory build have prompted upward revisions to Q4 GDP forecasts to 2% or a little above.  It reinforces the signal from last week's jobs data that the US economy has strengthened.   On top of this, the budget agreement, which has been approved by the House of Representatives, will reduce the fiscal headwind in 2014 a little bit more than had been expected.  

Many observers seem to think there is a direct line between these stronger economic reports and Fed tapering.  We are not as sanguine.  The case against December tapering had three planks.  Admittedly, the clarification of the fiscal situation removes one of the planks.  However, the other two planks are even more important.  The first is that inflation is very low.  The core PCE deflator, the Fed's preferred measure, is lower now than several months ago, when the FOMC upgraded its concern about disinflation.  

The second plank is the need to ensure forward guidance, upon which monetary policy will rely on during the transition from tapering to tightening, is credible.  To make it credible requires that the people who offer it are the people who will enforce it.  Given the pending changes at the Fed, including a significant change at the Board of Governors, it is clearly preferable for the Yellen Fed to taper and offer the new forward guidance.   Yellen will likely get confirmed next week.  We suspect shortly thereafter Bernanke will step down.  Yellen will then chair the late Jan FOMC meeting.  Although we have been anticipating a March tapering, a move in January, Yellen's first meeting as chair, is possible.  

The economic news stream today is light.  The fact that sterling found little support in strong economic data warns that 1) the strength of the UK economy has been discounted and/or 2) other factors are outweighing it.  The UK reported construction output rose 2.2% in Oct rather than the 1.6% Bloomberg consensus and the Sept data were revised to show a smaller decline (-0.5% rather than -0.9%).  Sterling has been pushed below its 20-day moving average (~$1.6290) for the first time since mid-Nov.  The technical indicators are deteriorating and the next immediate target is near $1.6230.  

The euro's pullback has thus far been more modest.  The $1.3700 area, which corresponds with a retracement objective of the latest leg up that began on Dec 3 near $1.3525 and the 200-hour moving average.  This area must be taken out to start to be anything significant.  We note that the 2-year interest rate differential between the US and Germany is stabilizing at low levels.  That said, we find that it is the change, not simply the level that is key.  Nevertheless, outside of the PPI figures, which tend not to be a market mover, the calendar is light and this may deny the market a sufficient excuse to look for the stops below $1.3700.  That said, resistance is seen in the $1.3740 area.  

The heavy euro and sterling tone has not prevented continued weakness of the dollar-bloc currencies and the yen.  The Australian dollar's attempt to carve out a near-term bottom was dashed by the bearish comments of RBA Governor Stevens.  Saying that the Australian dollar is over-valued is one thing.  To provide a specific target is quite another and seems to go against the spirit of G20 agreements.  At the end of last year and early this year, Japanese officials were criticized for essentially the same type of thing.  It is also a bit disingenuous for a central banker to talk about a nominal bilateral exchange rate and all the more since the US is not Australia's largest trading partner.  

Moreover, from a macro-economic and policy point of view, is a roughly 5% depreciation of a currency (on a bilateral nominal basis), given the volatility, really significant?  In any event, the bearishly disposed market was happy to do Steven's bidding, though rarely do the foreign exchange wishes of policy makers, drive prices.  The next immediate target for the Australian dollar is the year's low set in early August just below $0.8850.    Separately, the US dollar looks set to re-test the CAD1.07 area.  

The dollar is trading at new five year highs against the Japanese yen.  This comes despite a sharp upward revision to Japan's Oct industrial output (1.0% up from 0.5% initially).  The report boosts confidence that the Tankan Survey due out early Monday in Tokyo will also show improvement.  Yet, in Japan, as we have tried arguing about the US, it is not the real sector side of the policy making equation that is dominant now.  It is about prices (inflation).  The dollar approached the JPY104 level in Asia, but has drifted a bit lower in Europe.   Corrective pressures through the crosses (against sterling and euro) may prevent another test in North America today.