What will Drive the Dollar in the Week Ahead?

The dollar bullish divergence story appears to have hit a wall.  With US Q1 GDP likely to have contracted by around 1% at an annualized rate in Q1 and Q2 off to a weak start, whispers of a recession can be heard not only in the blogosphere but in the halls of the House of Finance.  The opportunity that the Fed is looking for to hike rates may not materialize.  

At the same time, the deflationary forces in the euro area have subsided.  The combination of the weak euro, low interest rates and the drop in oil prices provided the economic stimulus while policymakers await for the impact of structural reforms.  Now the recovery in oil prices is helped to put a floor under the general price level.    Market-based measures of inflation expectations, such as the difference between conventional and inflation-linked bonds and five-year/five year forwards show recognition of the diminished deflation threat.  Indeed, this realization appears to have been the spark that triggered the correction in European bonds, stocks, and euro.    

One might be forgiven for thinking that the US April CPI figure will contain important new inflation information.  Price pressures are expected to be little changed. Deflation is still likely evident at the headline level, and could actually deepen to -0.2% year-over-year from -0.1%.  Core inflation, which runs slightly higher than the Fed's core PCE deflator target may ease slightly from the 1.8% year-over-year pace seen in March.  

In contrast, a couple days before the US figures, the euro zone is expected to confirm their preliminary April inflation reading at zero at the headline level and 0.6% at the core level.  US core inflation, which includes housing costs is running nearly three times faster than the eurozone's which doesn't (~1.7% vs. 0.6%).  This is an important reminder that international comparisons of macro-economic are hindered by the lack of common methodologies.  

Separately, the US reports housing starts and new home sales.  Housing starts was one of the sectors in which weather seemed to play a depressing role.  They recovered in March and are expected to have accelerated in April.  Existing home sales have been stronger.  In March, they were already running at a faster pace than seen all of last year. April gains may be muted after the strong March rise (6.1%).  Nevertheless, an improving housing market is a net positive for the economy, but post-crisis, the size of the sector is considerably smaller than it was.  

The recent pattern in the market is for the dollar to be sold on disappointing news, but does not rally on better data.  We suspect this is an important reflection of market psychology.  It is consistent with our technical analysis, which warns that the dollar's downside correction may not be complete.  

In addition to the disappointing US data weighing the dollar, the unwinding of long European bonds have also spurred euro short-covering and took away the bid from the dollar more generally.  The economic reports in the week ahead will not provide new incentives sell European bonds and German bunds in particular.  The flash May PMI composite may ease from 53.9 in April, which would be the second consecutive monthly decline.  Separately, the German IFO and ZEW surveys may also slip.  

The UK reports April inflation and retail sales.  Consumer prices are expected to be zero year-over-year for the second consecutive month, but there is risk it could slip into negative territory.   The UK core rate, which excludes food, energy and tobacco are also expected to be steady at 1.0%.   After consumers went on strike in March, sparking a 0.5% decline in retail sales, British consumers returned to the shops in April.  Retail sales are expected to have risen by 0.4%.  That said, the year-over-year rate will slow to a 3.7% pace from 4.2% in March.  It would be the third month of slowing and would be the lowest since last September.  

Sweden's Riksbank holds a non-monetary policy meeting.  After the recent downside surprise on inflation, (-0.2% vs. consensus 0.2% year-over-year), an expansion of bond buying program is likely. With a minus 25 bp repo rate, the Riksbank is reluctant to push rates deeper into negative territory.  

The Bank of Japan meets, but it too is clearly on hold.  BOJ Governor Kuroda has been fairly adamant about it.  Although it has pushed the time frame for meeting the 2% inflation target from this fiscal year to next, he has explicitly denied the need for additional stimulus now.  This may change in going forward, but seems unlikely in the first half of the current fiscal year.  

Japan will provide a preliminary estimate of Q1 GDP.  It is expected to be in line with Q4 14's 1.5% annualized pace.  It looks like growth was concentrated inventory accumulation and exports, though business investment also probably improved from the small contraction seen in Q4 14.   The GDP deflator is soaring.  It was already at its highest level in at least two decades in Q4 at 2.4% and is expected to have risen to 3.6% in Q1 15.  

The minutes of recent Federal Reserve and Bank of England meetings will be published. Investors will be looking for color on the Fed's assessment of the economic headwinds, and perhaps some discussion on the criteria used to decide when to raise rates. That said, we again caution that the FOMC minutes have a high noise to signal ratio.  The signal generated by the Fed's leadership is diluted in the minutes where voting and non-voting members voice opinions and the context of discussions/remarks is often not disclosed.  

Given the less than dovish BOE Quarterly Inflation report, there is some risk that the minutes follow suit.  There is a slight risk that a hawkish dissent re-emerges.  Even though inflation remains non-existent, wages are recovering, and there is a concern about pass-through inflation stemming from sterling's past depreciation.  

At the end of the week there is an EU leaders' summit in Riga, Latvia.  Greece is not on the agenda but it is still the most pressing issue.  It is difficult to know precisely when Greece will run out of money.  It just borrowed from its reserve account at the IMF to make good its obligation to the very same IMF.    It needs to replace those funds in short order.  

As perverse as it might be, if Greece were to get a small tranche aid payment it would apparently have to be used to replenish that reserve account at the IMF.  The absurdity, and the fact that the Greek economy is contracting again (Q4 14 and Q1 15) means the situation cannot continue much longer.  

It is very generous of German Finance Minister Schaeuble to suggest that Greece hold a referendum to get the public consent to either meet the official creditor demands or to leave monetary union.  Yet it is simply preposterous.   Imagine a Greek official advocating a referendum in Germany of addressing the current account surplus that has been criticized by the EU, IMF and US or leaving the EU.  

Schaeuble does not get it.  A Greek exit, however, managed, would be widely perceived as a failure of German leadership.  Moreover, it would mean that the EMU is reversible, and every future crisis would become existential.  

It is not binary.  There are a number of areas in which the Greek government has met the official creditors' demands; such as streamlining VAT, tax administrative reforms, and privatizations.  The constant drum beat of our way (official creditors, as if they were all in agreement) or the highway is a false dilemma.  

Regardless of the personalities involved, there are two issues on which the Greek government has not capitulated. These involve labor market reforms and pensions.   Recall that only this year has France, who unilaterally decided it would not achieve the EU's budget deficit goal, enacted labor market reforms.   

There is no mechanism to eject a member from the monetary union.  Schaeuble and some others wish Greece were to leave on its own volition.   That train has left the station. Greece has been negotiating with the official creditors for nearly a year now to free up funds that have already been earmarked for it. Much of the improvement in Greece's macro-economic performance has been unwound, if not worse.   If Greece were to leave now, would there really be any doubt who pushed it?  

Europe's modest economic recovery (GDP in Q1 was 1% year-over-year) does not mean its congenital birth defects have been addressed.  It does not mean that the debt overhang has been absorbed.  Greece may be acting as a lightening rod, but even if it were fixed, serious challenges remain.  The problem of recycling the German surplus, for example, is unresolved.  The political backlash against the austerity regime is not limited to Greece, and will also reemerge as an important factor for investors.