What is Driving the Dollar?

There is a high degree of uncertainty in the global markets.   How deep into negative territory can nominal bond yields fall?  Has oil bottomed?  Are deflationary forces deepening? Will Greece remain within EMU, will the monetary union be stronger or weaker, as a result?

Returning to basics may be helpful in providing a ballast.  The investment climate was  shaped by the divergent economic outcomes from the different policy responses to the financial crisis.  The US and UK are ahead of the other high income countries.  Their central banks are expected to hike rates first, with the Federal Reserve going later this year, and now it appears likely the the BOE follows suit next year.

In the mean time, the ECB continues to ease monetary policy, and its sovereign bond buying program will begin next month and run through at least September 2016. The Bank of Japan continues its very aggressive unorthodox monetary policy.  It is expanding its balance sheet by 1.4% (of GDP) a month.  The BOJ targets core inflation, which includes energy, and it then adjusts for the sales tax increase last April.  By its own measure, despite the unprecedented pace of monetary easing, price pressures have been moving in the wrong direction. Many expect further easing later this year.

Two elements have been called into question.  First, the US economic growth has cooled after expanding around twice the pace of trend growth (labor force growth and productivity gains).  The 2.6% pace in Q4 14 is likely to be revised lower, possibly below 2%.  Growth in the current quarter is tracking around 2.2% according to the Atlanta Fed's GDPNow model.

Second, the decline in oil and interest rates, and the adjustment in the foreign exchange market are lending support to the world economy.  As we have noted,  the euro zone's real sector and financial data have been improving.  Money supply and bank lending have continued to recover.  Last week Q4 GDP was reported at 0.3% quarter-over-quarter, which was a little better than expected.   The flash PMIs for the eurozone will be reported at the end of the week ahead.  It is expected to confirm the modest pick up in activity has continued.  

Of note, the German locomotive got back on track, expanding 0.7% in Q4, which is faster than the US.  The stock market's nearly 12% advance this year will help lift the ZEW survey of investor sentiment.  Japan's April-September contraction ended as well.  We are likely to learn in Tokyo early Monday that the Japanese economy expanded by around 0.9% in Q4.

As the contraction in Q1 14 GDP did not prompt the Fed into changing its tapering course, we do not think that the return to trend growth from a quicker pace will prevent a midyear hike.  We continue to expect the forward guidance at the March FOMC meeting to evolve to confirm this as a possibility.

In mean time, the market will scrutinize the January FOMC minutes in the middle of the week. Appreciating that Germany and Japan grew faster than the US in Q4 will encourage the realization that the reference to international developments in the FOMC statement will also not preclude a midyear hike.

The Bank of England and the Reserve Bank of Australia also release minutes from their meetings earlier this month.  In both cases, though, more recent comments from officials have superseded the minutes.  The BOE's Quarterly Inflation Report acknowledged the downside risks to near-term inflation but expects the pace to pick up by the end of the year.   Growth forecasts for 2016-2017 edged higher.

Carney's reference to the central bank's willingness to cut rates if necessary is not the base view. Nevertheless, the December 2015 short-sterling futures contract rallied, with the implied rate falling by 16 bp in response.  Even more surprising then was sterling 2 cent rally against the dollar.  Over the past year, the 60-day correlation between sterling and the December short-sterling futures contract is nearly 88% (on a purely directional basis).

However, this week's UK data will include a likely steep fall in headline inflation and soft retail sales, which may not change these new dynamics.  The employment report is not expect to show much of a change in the pace that the unemployment queues are falling or weekly earnings growth.

The RBA's monetary policy statement likely steals whatever thunder there would have been in its minutes.  With a 65%-70% confidence, the market is pricing another rate cut, and the RBA did not lean against such expectations. The Australian dollar has fallen 5% this year and about 16.5% over the past six month.

The market is taking the Australian dollar (on a trend basis) in the direction that RBA Governor Stevens has indicated appropriate.  With this pace of adjustment, there was no need for the RBA to push it further or faster.  The market has taken the bit and is running with it.  That said, the downside momentum has faded, and technical factors warn of potential corrective forces.

The most interesting central bank meeting report will come from the ECB.  Until now the ECB has been reluctant to provide some record of its policy making discussions.  This is expected to change this week.  Neither the content nor format is understood yet, except that individual names will not be cited.

It was at the January meeting that the ECB decided to expand its asset purchase program from about 10 bln euros a month to 60 bln, which will include sovereign bonds.  While recognizing this is an important step in the transparency of the ECB, it is also a new channel of communication. Since the record can only be a partial summary of what happened, the ECB, like other central banks, will reveal what it wants.

The ECB is also expected to review its ELA authorization to Greece. Some claim the ECB's decision to no longer accept Greek government bonds as collateral was aimed not so much at Greece as to force both sides together.  However, it took place immediately following Draghi's meeting with Greece's new finance minister and not after Draghi's discussions with Berlin.  Surely the two sides would have been engaged in tough negotiations even if the ECB continued to accept Greek bonds.

Moreover, it assumes the ECB is some how impartial.  For Pete's sake, the ECB is part of the Troika and is an official creditor.  It is not just Greece that is critical of the Troika as such, but the European Court of Justice and the EC have recognized the conflict of interest for the ECB.   Indeed, there is no compelling reason the ESM does not buy out the IMF and the ECB's share of Greek debt.  Those new ESM bonds would be eligible for purchase under the ECB's new bond buying program.

Brinkmanship tactic require going to, well, the brink.  It was Eurogroup head Dijsslbloem that claimed the February 16 meeting of European finance ministers was some kind of deadline.    That does not really seem to be the case.  In any event, the market appears to be growing more confident that a compromise will be found, despite the fall in Greek bank deposits (some of the funds appear to be going to foreign banks in Greece).

The Greek stock market is up almost 30% from the late-January lows, and more than half was recorded in the last two sessions.  Greek's 10-year bond yield fell about 85 bp last week and is now down nearly 200 bp since the end of January.  The  3-year bond yield peaked last week at almost 22% and finished last week a little below 16%.

Commodity prices generally, and oil prices, in particular, have moved higher over the past couple of weeks.  Although the technical tone is favorable for additional near-term gains in oil, we think it is premature to think that the first bounce since OPEC's decision, not to cut production in late November is the bottom.   Speculators in the futures market have been accumulating a larger gross long position since the end of November.  

It is true that hostilities in Libya have reduced its supply and that the US rig count continues to fall quickly. Libya was producing around 350k barrels a day in January, but this may have dropped below 200k barrels now.  This trims the daily surplus that is still excess of one mln barrels a day and storage capacity is being filled.  

The US oil rig count has fallen by a third since October's peak.  Oil production last week is estimated at 9.2 mln barrels a day, a record and a 40k increase from the previous week.  The rig count is expected to continue to fall, and the historical experience suggests that the rig count is only half way to where it will fall in the coming months.   Global output has not peaked.  

Lastly, trying frame the state of monetary policy as a currency war does not yield fruitful results.  It is a strange war that the belligerents do not recognize.  Journalists and some analysts call it a currency war, but no one else.  The US, the EU, Japan, and even the BRICS have not accused any country of engaging in a beggar-thy neighbor strategy.  

It is a strange war that has such an obscure objective.  The three weakest currencies over the past six months are the Russian ruble that has lost 43% of its value, the Colombian peso which fallen 21%, and the Brazilian real which is off 19.5%.  All three raised interest rates last year (Russia cut rates this year).  Are they winning the currency war? Really?  

Sweden became the latest European central bank to adopt a negative official rate.  Some accused it of engaging in a currency war.  The krone has fallen 18.4% against the dollar and about 3.7% against the euro in the past six months.  It and the Norwegian krona (-18.8%) are the weakest of the major currencies over this period.  Sweden did not need to cut interest rates below zero for its currency to fall sharply.  

What do all the countries that have adopted negative interest rates have in common?  Not a strong currency, but deflation.  Central banks are fighting deflation with the only weapons it has--the price of money and the balance sheet.  The G20 endorsed countries use of monetary policy.   To call this a war is needlessly alarmist and plays into the hands of protectionists.  The reporters and analysts seem almost to be egging on the conflict the way adolescents might a high school brawl, and to what end?