Dollar Steady, Awaiting Key Events Next Week

The foreign exchange market is subdued. The yen and dollar-bloc currencies remain soft, while the European complex is flat. Even with limited movement, there are three currency developments to note.

First, the dollar made its eleventh consecutive new high against the yen. Negative yen pressure remains intact, but it does not appear to be true carry-trade driven in part because of the second development. This is the under-performance of the high-yielders. In particular, the Australian dollar has been pushed to new six-month lows, just below $0.9050. In fact, the dollar-bloc has competed with the yen this week for the worst performance.

Third, despite the latest polls from Scotland, including the YouGov survey, showing the "no" camp ahead, sterling has been unable to close the gap created by last Monday's sharply lower opening. Although sterling did make a new high for the week earlier today, it has stayed just shy of last Friday's low (the top of the gap) that was set near $1.6282, according to Bloomberg. The gap may be closed in North America today, but if not, the bearishness of this technical signal is strengthened. The disappoint construction output figure (flat instead of up 0.6% as the consensus expected) does not help matters, but what is weighing on sterling is not economic considerations, but politics.

The euro zone provided a rare upside surprise today. July industrial output rose twice what the market had expected. The 1.0% rise after a 0.3% decline in June is a good start to Q3. The strong German figures at the end of last week helped assure a favorable report. That said, Italy mightily disappointed with a 1.0% contraction in its July industrial output, which was well below the 0.2% contraction anticipated.

Another development this week has been the backing up of US yields. The 10-year Treasury yield rose 10 bp coming into today's session, and it is up another basis point now ahead of the retail sales report. Since the end of August, the yield is up 25 bp. The dollar's advance began prior to the rise in yields, but the rise in US yields lends support to the currency move.

Expectations for US retail sales have crept up to 0.6% at the headline level. The surge in auto sales may be blunted by the decline in gasoline prices. The measure used for GDP calculations, excludes auto, gasoline and building materials rose 0.1% in July, and the consensus expects a 0.5 increase in August. With the latest figures on service spending, many economists now expect an upward revision to Q2 GDP, and some are revising upward Q3 GDP, which seems to be tracking something north of 3.0%.

Prime Minister Abe, who is seeing his approval rating rise since the new cabinet was announced last week, met with BOJ Governor Kuroda yesterday. Kuroda's comments to the press help clarify the near-term outlook for Japan's money supply. Steady as she goes. QQE continues apace.

Earlier this year, there was an overwhelming majority that expected the BOJ to increase its monetary easing by the end of July. We favored a later time frame, if at all, on ideas that with the sales tax hike on April 1, officials have written off the April-June quarter, and would need to see how the economy performed in Q3. In addition, we argued that a supplemental budget would likely drawn upon too, if the fiscal shock proved to have more lasting impact (as we feared) than Japanese policy makers seemed to recognize.

Expectations for additional monetary easing have increased in recent weeks as most of the key economic data have been softer than expected, and inflation leveled off. However, Kuroda clearly indicated that while the BOJ is prepared to provide additional stimulus if needed (this is a truism for all central bankers), this was not the case at the moment. Inflation, he said, was steadily rising, and the economy is growing in the July-September quarter.

Although Japanese officials did not encourage the last leg down in the yen, as several European officials have done, they have welcomed it. Kuroda himself argued that it reflected fundamentals--the diverging economies and monetary policies. Some argue that renewed weakening of the yen would be problematic for the country as imports costs would increase. Yet, that is the point, isn't it? A depreciating currency would boost import prices and give domestic producers leeway to raise their prices. The weakening of the yen should renew the upward pace of inflation in the coming months.

The impact on the current account may be minimized by the sharp drop in oil prices, and commodity prices more generally. News that Japan took additional steps this week to restart a couple of nuclear plants in the south is also promising in the context of reducing the quantity of energy imports next year.

Lastly, we note that Swedish national elections will be held Sunday. The latest polls show the opposition coalition led by the Social Democrats enjoy the lead, which appears to have diminished in recent days. Any result that makes it appear difficult to form a strong government will likely weigh on the krona. The fundamental backdrop is soft with deflation and a loss of economic momentum.