US is not Driving Dollar

The US dollar is sliding across the board, but the impetus is not coming from the United States.  If anything, the combination of the strong auto sales figures, smaller trade deficit, and ADP jobs estimate underscore the fact that the US economy is recovering from the Q1 contraction.  Rather the trigger for the dollar's broad retreat is the strong gains of the euro, which seem inextricably linked to the sharp bund sell-off. The 10-year yield is approaching 1.0%, which means it has doubled since Monday's low print near 47 bp. 

The common narrative is that investors are attracted to the bund's high yield and buying euros to cover the transaction.  Under scrutiny this sounds backwards. Investors are selling bunds that is why yields are rising .  The euro first is lifted by the unwinding of short currency hedges but with technical levels breaking, momentum traders and leveraged accounts have jumped aboard.  

This new leg down for bunds did not begin with Draghi's awkward advice to get used to the more volatile environment.   It began the day before.  The lack of more sympathy from Draghi seemed to encourage the market to do what is was already doing.  The new leg down in the bunds began before the preliminary May CPI that showed the first positive inflation reading in several months.  It also began before the new optimism for a Greek deal.  

German bund yields are rising faster than in periphery.  However, Spanish and Italian 10-year bond yields are now near twice their low print.  If the economic recovery in the eurozone was fueled by the decline in the euro, low rates and low oil prices, the unwinding of these may temper the economic momentum just as it seemed to be leveling off in any event, judging from the recent PMIs. 

Yesterday, European equities appeared resilient in the face of the rising yields.  Today European bourses are lower.  The Dow Jones Stoxx 600 is off 1.5%, led by the interest rate sensitive utility sector, but the sell-off is affecting all industry groups.  

The sell-off in the US dollar, primarily against the European currency complex, should not obscure the better US economic news.  We think many investors do not appreciate the significance of May's strong US auto sales.  They were the strongest since July 2005.  They were 2% above last May's figures, which represented an 11% increase to their highest in nine years.  This is not only a testament to American consumers, but has output implications as well.  Specifically, Ford announced shortening its annual two-week summer shutdown to one week (at five of its North American plants) and FCA has canceled its usual seasonal shutdown at four factories in the US and Mexico.  

The ADP report suggests the fairly steady US job creation continues, and the March slump to 85k, was a fluke.   The details of tomorrow's US employment report are also important.  In particular, an increase in average hourly earnings would be helpful.  At the same time, the personal income and consumption data do point to rising US incomes being translated into higher savings.  Wages and salaries rose by about $125 bln in Q1.  

The smaller than expected US trade deficit also bodes well for Q2 GDP.  Recall that in Q1, next exports took 1.9 percentage points off GDP.  The real deficit (which is the key measure for GDP) narrowed to $57.2 bln from $66.4 bln.  It averaged $57.6 bln in Q1.    What all this means is that consumption in Q2 will be stronger than in Q1 and the headwind from trade will dissipate.  

It is true that the service ISM fell to its lowest level of the year. And the Beige Book was not particularly inspiring.  Yet this is precisely the kind of mixed data that one would expect if the economy is moving from contraction to expansion.  Moreover, both reports do point to a growing economy.  Recall too that the underlying trend of US economy is not what it was before the crisis. Yesterday the OECD cut its GDP forecast US growth this year to 2.0%.  We anticipate the Fed to make a similar adjustment when it meets later this month.  Even 2% growth may be sufficient to absorb slack in the economy.  

Clearly the next target in the euro is the high from mid-May near $1.1475.  The resistance may extend toward $1.1530. A break of this suggests potential toward $1.1600-50, which is the objective of the double bottom set in March and April.

The dollar-bloc is lagging in the move against the dollar.  Australia reported a dramatic worsening of April's trade balance and soft retail sales. The trade deficit swelled to A$3.89 bln from A$1.23 bln. This suggests that the positive contribution of trade in Q1 is reversing, and as we noted, Australia's growth in Q1 was a function of net exports and inventory accumulation.  Separately, Australia reported flat April retail sales.  They were expected to have risen by 0.3% and March series was revised to show a gain of 0.2% rather than 0.3%.  Many continue to look for an RBA rate cut in Q3.  

Separately, the New Zealand dollar is unable to keep pace with the European currencies.  The market has priced in about a 50% chance of a rate cut next week. The Canadian dollar is flat ahead of the IVEY report later today.  Sentiment has not recovered since the unexpected Q1 contraction was reported last week.  

The dollar continues to move broadly sideways against the Japanese yen.  After extending the rally at the start of the week, it has been consolidating.  Japanese officials appear to be  subtly trying to stabilize the exchange rate.  Today BOJ's Harada said that the yen's excessive strength has been corrected, though he refrained from highlighting some of the negative consequences of a weak exchange rate.  

Sterling is recovering from the drop at the start of the week below $1.5200.  With today's gains, it has retracement 50% of the drop since May 21 spike to $1.5700 ($1.5435).  The next retracement target is near $1.5500. Sterling has been unable to keep pace with the euro, against which its losing streak has extended into its seventh session.  The MPC meets today, but it is a non-event.   

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