Is the Dollar at a Turning Point?

On the most basic level, the key issue facing investors is whether the markets are at a turning point. The dollar had looked like it was going to break down, with the euro and sterling poised to have taken out the $1.40 and $1.70 levels respectively. 

The yen was also strengthening, pushing the greenback to the lower end of its three month trading range. Even the Canadian dollar, the worst performing major currency this year (-2.5% year-to-date) was advancing on the greenback. It had risen to its best level since January. 

Then, the US dollar staged a strong recovery last Thursday and Friday.  Draghi’s press conference may have been the precipitating factor, but the market had already discounted his “new”. Investors understood that the tick up in April’s CPI and the emphasis placed on the new staff forecasts, that the May meeting was not really “live” but the June meeting was. Confidence that the ECB is finally ready to act may have increased, but it needs to be kept in perspective and appears to be a great deal less than the dollar’s price action suggests. Specifically, the implied yield on the September and December Euribor futures contracts slipped by 1.0-1.5 bp on the week.

So even if it is recognized that the ECB is going to do something, it is not clear precisely what it is going to do. Draghi is among the first to point out that the central bank has a wide range of options. They range from the more conventional cut in the 25 bp refi rate and/or in the 75 bp lending rate to the somewhat less conventional cessation of sterilizing SMP purchases and/or extend the period of full allotment of monetary operations. There are more unorthodox options as well, such as quantitative easing, perhaps with a role for some of the roughly 750 bln euros of private ABS, (and some have suggested EFSF and ESM bonds) and/or a negative deposit rate.

The timing of the ECB action is important, but surely what it is going to do is just as important and here the unknowns are as great as ever. At the same time, the rally in the European peripheral bonds has seen absolute yields and premiums over bunds fall to levels that unimaginable. The international comparisons have just as noteworthy. Recently, Spain’s 5-year yield has fallen below the US yield and last week, Ireland’s 10-year yield fell below similar UK rates and is also threatening to fall below US rates.

The peripheral countries are smaller and have more debt than before the crisis. The decline in euro area interest rates may also serve as a constraint on the ECB. The unsustainable nature of the peripheral European bond market rally is becoming a more salient issue. In recent days, the IMF and some euro zone officials have expressed concerns. In addition to pricing for perfection, there is a fear that the lower interest rates ease the pressure for the economic reforms that arguably are still needed.

Moreover, some real and leveraged fund managers have been quoted in the press expressing concern about valuation. Before the weekend, as the euro extended its key downside reversal recorded on Thursday, peripheral bond yields were firmer (10-year yields rose 3-4 bp in Italy and Spain and 8 bp in Portugal). Spanish and Italian stocks under-performed before the weekend, as well.

The euro’s performance, and by extension the general direction of the US dollar, may turn on one’s outlook for the peripheral European asset market. In the week ahead, that may be a function of the new economic information and the direction of US Treasuries. There are two main reports from the euro area. On Thursday, May 15, the final April CPI estimate and Q1 GDP will be reported.

The risks are that the data encourages further profit-taking and position adjustment in the periphery asset markets and implies scope for additional euro losses (which is consistent with our technical outlook). If anything the April flash CPI gain of 0.8% may be revised higher. In terms of growth, the euro economy likely expanded at twice the Q4 13 pace of 0.2%. The risk is on the upside here too.

Turning to US Treasuries, the 10-year yield is at the lower end of this year’s range. It has been unable to sustain a break of the 2.60% level. The risk is on the upside, and downside for prices. A backing up of US yields could weigh on the European bond markets. 

There are several important readings on the US economy in the coming days, including retail sales, industrial output, inflation and housing starts. On balance, we expect the data to be consistent with a sharp rebound in the US economy after Q1’s stagnation or worse. Indeed, given new data, it is possible, nay, likely that the US economy contracted in Q1. We have warned that the weakness in Q1 GDP will likely be reflected in the Fed’s GDP forecasts for the full year to be trimmed in June, even as it will recognize that the headwinds were largely transitory.

Yellen expressed concern about the housing market, where the softness began being apparent last fall. A gain in April housing starts (scheduled for release at the end of the week); will be seen as a favorable sign. Perhaps the weather exaggerated pre-existing weakness.

Separately, headline CPI is likely to jump to 2.0% from 1.5%. It is only once been above there since Q2 12. Headline CPI is more important to investors than core CPI (expected to be steady at 1.7%), which may rightfully have a greater role in terms of policy. The rise in the headline rate will partly be due to base effects, which will likely be reversed in the next couple of months.

April retail sales are likely to be firm as US households continue to shop, albeit sans the credit cards. The market already knows that overall auto sales were softer, but chain store sales appear stronger. Consider the component used for GDP calculations that excludes autos, gasoline and building materials. It has been extremely steady, having risen an average of 0.23% over the past 6, 12, and 24 months. The consensus forecast for the April report is 0.5%, or twice the average. This follows a 0.8% increase in March. This report too may be consistent with higher rather than lower US bond yields.

Outside of this key nexus of US interest rates and European peripheral asset markets in driving the dollar, there are three other lesser drivers: Japanese data, UK's employment report and the central bank's Quarterly Inflation Report, and geopolitical tensions.  

The first readings of the Japanese economy since the sales tax increase will be reported.  Data from the first quarter, including March current account balance and even Q1 GDP, are not likely to elicit much of a market response. The 3% sales tax increase April 1 is a new before and after moment. Economic sentiment likely deterioration sharply and money supply growth likely slowed. The corporate goods price index will show a large jump (consensus is for a 2.8% rise on the month for a 4.0% year-over-year gain). The BOJ’s reference measure for its 2% inflation goal is the CPI, excluding fresh food (core, which does include energy) and the sales tax increase. We not that the GDP deflator is still likely to show slight deflationary forces remain.

The Bank of England’s quarterly inflation report, which is the vehicle of forward guidance, and the latest labor market readings are the highlights of the week. By reducing its inflation projections, the BOE will underscore its argument that it is in no hurry to raise interest rates. The discussion of economic slack will attract attention. Macro-prudential measures to address concerns about the housing market would also reduce one source of pressure for an early rate hike.

Geopolitical tensions remain elevated and in testimony before Congress, Yellen included these as economic risks. The EU appear poised to add more individual names to its asset freezes and visa bans, which will bring it more into alignment with US sanctions. The EU does not yet seemed prepared to escalate the sanction regime to “stage two," which would allow it to include companies and organizations. The US seems more prepared for “stage two” but is being held by the EU’s reluctance. Disruption of the May 25 Ukraine election, however, would likely push the EU over that Rubicon.

Tensions over the territorial disputes with China have been gradually escalating. This is not just about Japan as seemed to be the case a year ago. The dispute between Philippines and China is simmering. Now China and Vietnam’s conflict is surfacing. Given the recent signal by the US that the Philippines and Japan’s claimed islands fall within its security treaties, Chinese officials may choose Vietnam to send a broader signal to others in the region.

In conclusion, we take the middle ground between those who think this is simply minor short covering bounce in the dollar and those who think that the long awaited turn is at hand.  We suggest the positioning adjustment has more room to run and this week's events look likely favorable fodder.  A rise in US yields, helping to lift peripheral European yields, may weigh on the complex of European currencies, which is consistent with the deterioration in technical tone seen in at the end of last week. A rise in US yields may also lend the dollar support against the yen.  The BOE is likely to push back against market speculation that the continued strength of the economy will lead to an earlier rate hike and, given the current environment, spur a further pullback in sterling.