No USD Recovery Until Yields Stabilize

Dollar: No Recovery Until Yields Stabilize

At the beginning of the week, we said the dollar was due for a recovery but this view hinged on stronger data and a rise in U.S. yields.  Unfortunately since then there has been just much deterioration as improvement in U.S. data and the lack of consistency drove 10-year yields below 2.5% to its lowest levels in 11 months. The good news this morning included an uptick in consumer prices, acceleration in manufacturing activity in the NY region and the drop in jobless claims. For the first time in 6 years, weekly jobless claims rose by less than 300k and while this is encouraging, the pace of hiring has not kept up with the decline in firings.  Consumer prices also rose at its fastest pace in 10 months, which when combined with the drop in claims should have driven the U.S. dollar and U.S. rates higher.  However instead of rising, yields fell as investors discounted the report on the belief that it would not affect Fed tightening. An hour later, yields pushed even lower after the industrial production, Treasury International Capital flow and Philadelphia Fed manufacturing reports surprised to the downside. IP fell 0.6% in the month of April against expectations for no change.  Manufacturing activity in the Philadelphia region also grew at a slower pace in May -- validating the central bank's view that parts of the U.S. economy still need support.  According to the TIC report, foreign investors sold -$126 billion worth of U.S. assets in March, the month that Janet Yellen decided to proceed with tapering.  Although the decline was largely due to changes in banks own net dollar denominated liabilities, it is also worth noting that tapering alone has not been enough to encourage inflows.  U.S. yields may not stabilize until we have consistent improvements in U.S. data, which means that for the time being, the trend in the greenback could still be lower.  However eventually this dynamic will shift, providing underlying support for the greenback.

EUR: Weak GDP and Low Inflation Support June Easing

The euro ended the day unchanged against the U.S. dollar, but not before hitting a 2-month low at the start of the North American trading session. The intraday reversal in EUR/USD was fueled entirely by the sell-off in the greenback because the latest economic reports gives the European Central Bank a stronger reason to ease next month.  EUR/USD achieved our initial target of 1.3650 and even after Thursday's recovery we believe the pair will eventually drop below 1.3600. Low inflation in the month of April and weak GDP growth in the first quarter highlight the deep challenges in the Eurozone.  According to our colleague Boris Schlossberg, "The EZ GDP for Q1 missed its mark badly printing at 0.2% versus 0.4% eyed as the economic polarization between Germany and the rest of Europe intensified. German GDP actually beat the forecasts printing at 0.8% versus 0.7% projected, but French GDP showed no growth at all 0.0% vs. 0.4% expected and Spanish and Italian GDPs actually contracted. The sharp difference between German performance and the rest of the EZ served to highlight the structural challenges in the region where growth is very unevenly divided and created a sense of urgency for further stimulus from the ECB. To that point a report in Spanish newspaper La Vanguardia suggested that the ECB will cut its deposit rate to -25bps at the next meeting in June and will also lower the lending rate to 15bps. Lastly the EZ CPI readings remain extremely low with core inflation coming only at 0.7% well below the ECB's target rate of 2.0%. With price levels clearly stuck near deflationary levels the ECB is now likely to act in June and currency markets are beginning to price in this easing." Although the sell-off in EUR/USD is being tempered by the decline in U.S. yields, in order for the currency pair to extend its losses U.S. rates needs to stabilize. 

Sterling Rebounds but Beware of Further Losses                     

The slide in U.S. yields triggered a sell-off in the dollar that drove the British pound higher Thursday. After nearly six days of consecutive losses, sterling rebounded against the greenback and while we still believe that the Bank of England's reluctance to tighten monetary policy is negative for pound, the decline in U.S. rates has been the main driver of currency flows.  No U.K. economic reports were released Thursday and nothing is scheduled for Friday.  Sterling will be back in play next week with CPI, Retail Sales and Q1 GDP scheduled for release.  In the meantime, we view any bounce in sterling as an opportunity to sell at higher levels as expect more unwinding of long GBP/USD trades.  By maintaining their current inflation and growth forecasts, the Bank of England's dovish monetary policy outlook makes it clear that they won't bend to the market pressure and raise interest rates prematurely.  If the government wanted to curb inflationary pressures, which is confined to housing the first step would be taken by the Financial Policy Committee who could scale back the Help to Buy Scheme or impose restrictions on mortgages.  We don't expect much volatility in the GBP/USD over the next 24 hours.

CAD Holds Onto Gains, Glimmer of Hope in Housing

The Canadian dollar held onto its gains against the greenback while the Australian and New Zealand dollars retreated.  The recent improvement in housing market activity is giving the Canadian economy a glimmer of hope.  Earlier this week we learned that house prices increased in April and Thursday, existing home sales rose 2.7%.  At the start of this year, we said the biggest risk for Canada in 2014 is the housing bubble.  According to a report from the OECD at year's end, Canadian house prices were 60% higher than their long term average on a price to rent basis. The Canadian government has taken a variety of steps to engineer a gradual slowdown in the sector and to avoid a crippling crash.  Based on this week's housing market reports, they are doing a good job of ensuring a soft and not hard landing.  Manufacturing sales, which rose 0.4% in March, also supported the weakness in USD/CAD Thursday. No major economic reports were released from Australia but a sharp decline in New Zealand's Business PMI index drove the New Zealand dollar lower.  Growth in the manufacturing sector slowed significantly last month with the index falling from 58 to 55.2, its lowest level in 7 months.  According to BNZ, the agency that releases the report, the decline in April appears to be holiday induced, trends in PMI are strong and especially so in employment. While this may be true, it gives the RBNZ yet another reason to keep rates steady next month.

JPY: Rise in Capex is Good News for Japan

Last night's stronger than expected first quarter GDP numbers drove the Japanese Yen higher against all of the major currencies with the rally extending on the back of weaker U.S. data. Everyone from economists to investors and traders expected pre-tax spending to drive strong growth in Q1 and demand was so robust that on an annualized basis, the economy expanded by 5.9%, the strongest pace of growth in over 2 years.  On a quarterly basis, GDP rose 1.5% against expectations of 1.0%. What is interesting about the report is that while consumer spending picked up significantly (+2.1% growth), the big surprise came from business spending, also known as capital expenditures which rose 4.9% compared to a forecast of 2.1%. It is this increase in capex that could help support the economy in Q2 as consumer spending slows.  Thursday's consumer confidence index shows that consumers are growing less optimistic and while we are encouraged by Thursday's GDP numbers, how the economy performs in the second quarter is key.

Kathy Lien, Managing Director of FX Strategy for BK Asset Management.