Dollar Extends Recovery, but Still in Range

The US dollar is broadly higher on follow through buying after recovering in North America yesterday, helped in part by the FOMC minutes.  The minutes suggested a greater risk of a June or even a September hike than many investors seem to appreciate.  The December Fed funds futures contract, for example, has nearly unwound the move spurred by the disappointing jobs data at the end of last week.  

The FOMC minutes shed light on the role of the dollar.  Its strength was a reason for some cutting the long-term growth forecasts, and by implication the lower level of Fed funds in 2017. On the other hand, it is noteworthy that the stabilization of the dollar was cited as a factor that would help boost confidence that price pressures would move toward the Fed's target.  

The minutes also showed the Fed's progress on operational issues.  As we have noted before, the Federal Reserve now targets a 25 bp Fed funds range, not a fixed point as it has in the past.  It will continue to do so.  The interest on excess reserves will be set at the top of the range.  The bottom of the target range will be the offering rate on reverse repo operations.  However, the sense from the minutes is that Fed officials are less comfortable with the reverse repos as a permanent facility.  

There are still outstanding issues, but Fed officials appear to be making good progress.  The issue of the Fed's balance sheet, however, is still being discussed.  There are around $250 bln Treasuries that mature next year and estimates suggest nearly as much mortgage-backed securities (including making some conservative assumptions about pre-payments).   How fast this is permitted to shrink the balance sheet is not clear.  However, this is one of the reasons that rate hikes will be gradual. 

Today's news stream is light.  The UK reported a wider than expected trade deficit.  The goods deficit swelled to GBP10.3 bln after the January deficit was revised to GBP9.17 bln from GBP8.4 bln.  Trade with non-EU countries accounted for the deterioration.  That deficit widened to GBP3.24 bln from a revised GBP1.97 bln (from GBP1.75 bln).  The market is looking past today's Bank of England meeting.  With fears that the UK election will not produce stable government, market participants hardly needed the excuse to sell sterling.  Yesterday's M&A news failed to lift sterling above $1.50, which has been the cap for month now, and instead slipped to new six day lows near $1.4765.  Support is seen in the $1.4720-50 area.  

After yesterday's dismal German factory orders data (-0.9% in February vs +1.5% consensus), the market had been prepared for a disappointing industrial production report today.  Instead, there was a pleasant surprise.  Industrial output rose 0.2%.  This was offset by the sharp downward revision in the January series to -0.4% from +0.6%.   This brought the year-over-year rate to -0.3%. 

Separately, Germany reported a slightly wider than expected February trade surplus of 19.2 bln euros after January's 15.9 bln euro surplus.  Exports rose 1.5% on the month.  They had fallen 2.1% in January.   Imports were up 1.8%, snapping a two-month decline.  The consensus was for a 1.2% increase.   Germany's large external surplus is a source of criticism not just from the US, but from the EU and IMF as well.  The common German retort is that its exports are a reflection of the quality of its workmanship and that a less competitive Germany would do little to address the main obstacles to structural reforms in France, Italy, or Greece for that matter. 

Nevertheless, the German export model will benefit from the weaker euro and lower interest rates.  Moreover, the German surplus used to offset the deficits in the less competitive periphery (and France).  However, this is not needed as much, as demand compression coupled with internal devaluations have improved the peripheral external accounts, producing a larger overall eurozone current account surplus. 

The US earnings season formally kicked off yesterday with Alcoa's report, but the equity story that is dominating market interest is Hong Kong.  There has been a flurry of buying from Chinese investors.  The Hang Seng rose to seven-year highs.  Its 2.7% gain today brings its five-day advance to 8.4%.   Two factors are at work.  

First, the strong gains in the Shanghai Composite led to a large valuation discount of Chinese shares that trade in Hong Kong. Second, Chinese officials have made it easier for domestic funds to the HK-Shanghai equity link.  The quota has been hit for the past two days (CNY10.5 bln a day).  Over the past four months, since the link opened, Chinese investors used less than 20% of their quota to purchase HK traded shares.   Last month, China expanded the link access to more Chinese funds.  There is much speculation that China will soon raise the quota.