Dollar Divergence Moves Into Overdrive

The US dollar is extending its advance as the divergence theme moves into overdrive. The dollar has drawn close to JPY119.50. The euro has fallen to new lows near $1.2320, having been turned back from $1.25 on Monday. The Australian dollar has been pushed briefly below $0.8390.

The main exception is sterling, which is holding its own after a stronger than expected service PMI. Although it slipped below yesterday's low, Monday's low near $1.5585 remains intact, and sterling is trading around 3/4 a cent above there near midday in London.

The divergence theme has been underscored by the comments of Fischer and Dudley reaffirming the signal by Fed leadership that a mid-2015 rate hike is still "reasonable". The disinflationary impulse from the drop in energy prices is temporary. Instead, they emphasized the growth implications.

There has been a backing up of US interest rates too. The U.S. 2-Year yield is near 55 bp, which is the upper end of the range seen in recent weeks, and represents a 10 bp increase since Monday's lows. There is increased speculation that the "considerable period" phrase in the Fed's statement is likely to be diluted or dropped as early as this month. Meanwhile, the 10-Year yield is near 2.30%, which is a 15 bp increase since Monday's lows.

In Europe, the service PMI was slightly disappointing at 51.1 from 51.3 of the flash and 52.3 in October. Germany was unchanged from the flash (52.1) but France's downward revision wipes out the improvement that the flash suggested. France's service PMI slipped to 47.9 from 48.8 of the flash and 48.3 in October.

The pleasant surprise came from Italy. The November service PMI rose to 51.8 from 50.8. The consensus was for 50.2. It was Spain that disappointed. The service PMI fell to 52.7 from 55.9. The market had expected a smaller decline to 55.2.

In addition, the euro area October retail sales in October rose 0.4%, slightly less than expected, and managed to retrace only a small part of the 1.2% decline in September (was initially -1.3%). This week's data provides a poor backdrop for tomorrow's ECB meeting. Everyone agrees that the ECB staff is going to cut its forecasts again and the Draghi will be dovish. This goes practically without saying. The key issue is whether the ECB expands the assets it is purchasing (to include supra-nationals, like EU, EIB, EFSF, ESM bonds which we think are "low hanging fruit), or does it announce its intentions to buy sovereign bonds, as some expect.

The market took the Australian dollar lower in response to the poor Q3 GDP figures. The economy expanded by 0.3% on the quarter, less than half the pace the consensus expected. The RBA statement earlier this week had spurred a reassessment of a rate cut the market was pricing in for next year. However, today's weak growth figures have seen such pressure renew. Still, ahead of tomorrow's retail sales and trade balance reports the interest rate adjustment is modest. The Australia 2-Year yield is off 5 bp today to 2.38%. It had reached 2.45% earlier in the session. The low before the RBA meeting was near 2.36%. This level should be taken out as a cut is further discounted.

China reported service PMIs. The official one ticked up to 53.9 from 53.8. The HSBC measure also ticked up, from 52.9 to 53.0. It does not impact expectations that the PBOC is likely to cut the reserve requirements in the next week or so. The dollar has quietly firmed against the yuan and reached almost CNY6.1550 today, its highest since late September. Because the yuan shadows the dollar, despite the flexibility the PBOC claims to have introduced, the yuan has appreciated on a trade-weighted basis. It will continue to do so, even if it edges lower against the dollar.

The North American session will be busy. The Bank of Canada meets. It is expected to leave rates on hold. We look for the Bank of Canada's statement to emphasize that it is looking through the pick up in price pressures as transitory. There are three US reports to note: ADP, ISM services and the Beige Book. Note too that UK's Osborne will make the Autumn Statement (budget). Separately, it has already been announced that the Funding for Lending Scheme, which aims at increasing credit to small and medium-sized businesses has been extended for another year.