What a difference a week makes. Last week's US employment data had put the dollar bulls back into control. Developments over the last 24-48 hours have seen the reins slip from their hands.
Three developments in particular have spurred the bout of profit-taking that has weighed on the greenback. First, the cease-fire in Ukraine. Yes, it is not the first cease fire, and yes there are reasons to be skeptical of its duration. However, the diplomatic development at least postpones any escalation of hostilities or sanctions. It must be understood as a positive development.
Second, even though a compromise on Greece has not been secured, investors feel more confident that an agreement will be reached. Greek bonds and stocks are continuing yesterday's strong recovery. Technical discussions are underway between Greece and the official creditors (ECB, IMF and EU), but the fact that they are not called the Troika illustrates the face-saving efforts underway. Previously the Eurogroup head indicated that February 16 was the deadline for an agreement on the grounds that some national parliaments need to approve any new deal. However, the pendulum of market sentiment has swung away from Grexit, and even if a new agreement is not fully agreed upon, progress will likely be reported that will keep sentiment intact.
Third, yesterday's US retail sales report was disappointing. The headline decline of 0.8% was twice what the market expected. This could have been dismissed because of energy prices. However, the core measure, when excluding gasoline, autos and building materials, was soft too (0.1% vs. consensus of 0.4%). This too weighed on the US dollar, where the speculative positioning was bulled up.
Yet we caution against exaggerating its significance. What is key is household consumption. Retail sales account for less than half of household consumption. Personal consumption expenditures is a more comprehensive measure. Consider that in Q4, the monthly change of retail sales added up to -0.2%. The core measures was up 0.7%, using the same methodology of adding the monthly changes. The PCE component of GDP rose 4.3% at an annualized rate, the strongest since 2006. This illustrates that retail sales are noisy and the things that US consumers are buying may not get picked up in retail sales right now.
That said, some pullback from Q4's heady pace would not be so surprising. Moreover, due to recent trade and inventory data, Q4 GDP is expected to be revised lower, towards 2%, while estimates for Q1 are being trimmed towards 2.5% from 3.0%. We are not convinced that this will materially impact next month's FOMC meeting. The US economy was growing above trend, which is seen as closer to 2.0%-2.25%, given labor force growth and trend productivity. Policy making is also forward looking. Just like the unexpected contraction in Q1 14 GDP did not alter the Fed's tapering path, at this point we continue to think the odds favor the Fed modifying its forward guidance ("patience" ) in next month's statement that will keep a mid-year hike as the central scenario.
The economic news stream from Europe has also spurred some dollar profit-taking. The Bank of England's Quarterly Inflation Report was more optimistic and less dovish than many expected. It is still seen as the second most likely central bank to lift rates, after the Federal Reserve. Sterling has bounced four cents off last week's low. The next technical target is $1.5480-$1.5500.
The euro zone Q4 GDP was better than expected with a 0.3% expansion. The consensus had expected a 0.2% pace, the same as in Q3. Germany's 0.7% quarterly expansion lifted the region. It was expected to have only expanded by 0.3% after a 0.1% expansion in Q3. Details are not yet available, but it looks like both foreign demand and domestic demand helped the economic locomotive get back on track. France eked out a 0.1% expansion after posting 0.3% growth in Q3. Italy, the third largest economy in EMU stagnated, which was better than the 0.1% contraction that was expected.
The euro closed above its 20-day moving average yesterday for the first time in two months. That area, around $1.1380 should now act as support. Once $1.1445, on the upside is overcome. The next technical target is in the $1.1500-25 area.
The Australian dollar bounced nearly 2% off yesterday's lows. This reflected the heavier US dollar tone. Comments by RBA Governor Stevens did not talk down the currency as he has in the past, though he acknowledged that a further adjustment is likely. Recall that he previously talked about the $0.7500 area as being appropriate. The stabilization of many commodity prices may have also discouraged new shorts after the disappointing employment data. A move toward $0.7800 would not be surprising. The market still favors a March rate cut, but we are somewhat less sanguine.
Japan had another poor bond auction. The 5-Year bond sale saw the lowest bid-cover in nearly two years. Japanese government bonds have performed miserably lately. Note that the 10-Year yield neared 45 bp today, the highest since early December and more than twice the yield that prevailed as recently as January 20. The effect on the exchange rate was minimal when US yields were rising, but the US 10-year has stalled just above 2% and they are below there now. This coupled with yesterday's report, suggesting: 1) BOJ is not in a hurry to expand QQE despite what is expected to be further easing of CPI and 2) the suggestion, on the heels of the recent G20 meeting, that further yen weakness may not be desirable, has seen the dollar pullback from the JPY120.50 area that had been approached Wednesday and Thursday. Support now is seen near JPY118.30, but if this goes, another move towards JPY 116.60-JPY 117.00 looks possible from a technical perspective.
Today's North American session will be light on news. US import prices may offer some insight into next week's PPI report. The Fed has been giving more weight to the surveys of inflation expectations over market measures (like break-evens) and the University of Michigan's survey is expected to confirm stable long-term outlook. Lastly, even though the US oil rig count is not closely tied to output, a continued fall is understood to be a leading indicator, as the capex plans indicate that many will not be replaced. Over time this will translate first into slower growth in output and then a decline in output. This still seems several months away.