What's Fueling U.S. Dollar Strength?

It is fairly straightforward. There are two drivers of the dollar's strength. First are the supportive developments in the U.S. This is the growing confidence that the Fed's employment and price mandates are being approached, without unduly jeopardizing a third mandate of financial stability. There has been a small rise in U.S interest rates over the past couple of weeks, and we have suggested that the low is in place for U.S. 10-Year yields.

Yesterday's San Fran Fed paper indicated that investors are under-estimating how quickly policy makers could raise key borrowing costs relative to Fed officials is also underpinning U.S. interest rates today. Its argument was based on low volatility. The information is not new, and the FOMC will update its forecasts next week. This divergence is understandable. As we have argued, while all Fed presidents are free to express their opinions, the key to understanding Fed policy is to watch the leadership—Yellen, Fischer and Dudley. Several regional presidents are more hawkish then this troika seem to be. The unvarnished truth is that investors ought to give more weight to the troika's views. Everything is not equal.

The second leg of the dollar's support is coming from foreign developments. The euro's decline has accelerated following the ECB's decision to cut interest rates (and leaving the market with a 20 bp negative deposit rate) and plans to expand the central bank's balance sheet. The ECB's Nowotny has confirmed that the rate cuts will help weaken the euro. The decline in the euro will help boost inflation and provide some support for the periphery of Europe. German yields are negative through 3-Year and nine EU countries have negative 2-year yields, including Ireland and Slovakia.

The euro recorded a low near $1.2860 in early Europe, after being unable to rise above $1.2900 in Asia. Despite the extended positioning, the short-term market continues to show a bias toward selling into even minor upticks.

News from Japan has been disappointing. The impact of the sales tax hike, and, perhaps fear that it will be hiked again, as currently planned in October 2015 to 10% (from 8% now and 5% at the start of this year). News earlier today showed the tertiary sector (aka services) was flat in July compared with expectations for a 0.2% increase. There appears to have been an increase in portfolio outflows from Japanese investors, and suspicions that the government pension funds are participation.

Speculative participants have built a significant short yen position in the futures market, and this too has accelerated since the dollar broke out of its four-month narrow trading range (JPY101-JPY103). We have often found that the dollar-yen appears to trend as it moves from one trading range to another. The dollar reached almost JPY106.40. This renewed yen weakness may help reignite the upside pressure on Japanese inflation, which has stalled in recent months. We suspect the upper end of the new range may be closer to JPY110, but it is far from clear at the moment.

The break higher was not precipitated by wider interest rate differentials. This time the currency led the rates, but the rates have moved too. The U.S. 10-year premium has risen more than 10 bp since the end of August.

What ails sterling the most is not an economic story. In fact, today's industrial production report, like last week's service and construction PMIs, were stronger than expected. The 0.5% increase in July industrial output was more than twice the Bloomberg consensus. Manufacturing output rose 0.3% as expected and this was sufficient to lift the year-over-year rate to 2.2% (from 1.9%). BRC August retail sales were also considerably stronger than expected (1.3% vs 0.3% expected).

Sterling's main problem is political. The ayes and nays of the Scottish referendum are neck-in-neck, as opposed to expectations a little more than a week to go. A victory for the independents risks a serious political crisis, and also dramatically increases economic uncertainty. Through last Tuesday, the end of the CFTC reporting period, speculators in the futures market were still net long pounds. This may have been reversed over the past couple of sessions, while momentum traders jumped about the southern express.

The worst outcome is a close vote. This critical decision needs a simple majority. It is not clear why such a low threshold was agreed upon by London in the first place. A small "no" victory risks continued efforts for independence, as was previously seen in Quebec. A small "yes" victory risks a weak Scottish negotiating hand over the 18-months following the referendum before actual independence takes place.

The North American session features the U.S. Job Opening and Labor Turnover Survey (JOLTS). Given the wider view of the labor market that the Yellen Fed is considering, this report has taken on greater importance. Job openings are expected to have risen toward 4.7 million in July, which would be the sixth consecutive increase. The quit rate may have tick up (~1.8%-1.9%), but remains well below the 3.1% pace seen before the crisis. Today begins this week's U.S. Treasury sales of $61 bln in notes and bonds. U.S. 10-year yields are up for the fourth consecutive session, a streak not seen in three months.