Big Week Ahead For The Dollar

Investors sold U.S. dollars this week on the growing belief that the Federal Reserve will pass on reducing asset purchases this year. Since the U.S. government was shut down at the beginning of the month, more investors started to adjust their positions in currencies in favor of tapering in 2014 versus 2013 but the selling accelerated when non-farm payrolls missed expectations. At the time, investors realized that it would be extremely difficult for the central bank to justify reducing stimulus with job growth slowing. Next week we will get to hear from the horse's mouth (the Federal Reserve) and see whether the market's expectations are aligned with central bank's view or if they are overly pessimistic. While there is no post monetary policy meeting press conference scheduled for next week, the FOMC statement should provide clues on whether a move in December is still possible. We believe that it is unlikely given the economic impact of the U.S. government shutdown and the reliably of October data. Therefore if the statement contains more skepticism or hesitation, the dollar could resume its slide, pushing many of the major currency pairs to new highs. However if the Fed is still committed to tapering and open to doing so in December, it would catch many traders by surprise and that could translate into a relief rally for the greenback

Aside from the FOMC meeting, a laundry list of U.S. economic reports will be released including the delayed retail sales and industrial production reports along with Consumer Confidence, the ADP employment change, Chicago PMI and ISM Manufacturing index. Unfortunately we are looking for broad based weakness with confidence hit by the government shutdown, spending slowed according to other similar reports released by the International Council of Shopping Centers and Johnson Redbook as well as softer manufacturing activity as seen in the NY and Philadelphia regions. If the data is weak, especially in the front of the week, the dollar could extend its slide on the growing expectation that tapering will not happen until 2014. As only second tier U.S. data was released Friday, the performance of the dollar was mixed. Consumer confidence was even weaker than the University of Michigan had initially anticipated and despite a solid 3.7% increase in durable goods orders, excluding a sharp rise in aircraft demand, durable goods actually fell 0.1%, making the overall release a net drag on the dollar.

EUR: Shrugs Off Weaker German IFO
The euro ended the day unchanged against the U.S. dollar after hitting fresh 23-month highs in the early European trading session. The currency shrugged off a weaker than expected German IFO report that showed business confidence deteriorating in the month of October. The expectations index dropped to 107.4 from 108.2 while the current conditions index edged slightly lower to 111.3 from 111.4. With the PMI reports showing a slowdown in euro zone economic activity this month, German businesses grew less optimistic about the future conditions. U.S. fiscal troubles didn't help either but in general, the index remains near one-year highs so there's no need to ring any alarm bells. Over the past few months, we have seen a gradual improvement in the euro-zone economy, so a one-month pullback is not out of ordinary. If this deterioration becomes a trend, then it is a big problem. While the ECB has not made any direct comments about the currency, if the EUR/USD continues to rise, it could have a larger impact on economic activity. German unemployment and retail sales figures are due for release next week and economists are looking for stronger numbers all around. If euro-zone data beats expectations and U.S. data misses, the EUR/USD could extend its gains towards 1.40

GBP: GDP Growth Accelerates In Q3
The British pound traded lower against the U.S. dollar and euro despite satisfactory third quarter GDP numbers. As reported by our colleague Boris Schlossberg, "In UK today [Friday] the first print of Q3 GDP came in line at 0.8% which was the best reading in a year. The boost in GDP growth came mainly from construction, which saw a jump to 2.5% from 1.9% in Q2. The UK economic recovery is showing real momentum according to the country's Treasury and the expectation is that growth will continue on pace into the year end. Cable saw a small bounce on the news but remained below the 1.6250 level. The pair continues to struggle with making new highs as it faces a wall of resistance around the 1.6300 figure. At the same time however, the pair has held up remarkably well above the 1.6000 level and if it can sustain that support it may make another run on the yearly highs over the next few days." However a move to new highs next week would most likely be driven by the market's appetite for dollars because there are no major U.K. economic reports on the calendar until the end of the week when the PMI manufacturing index will be released. The front of the week will be all about the timing of tapering and what is expected to be the sluggish pace of growth in the U.S. at the end of the third quarter.

NZD Extends Losses On RBNZ Comments
Commodity currencies extended their losses against the U.S. dollar Friday despite a small uptick in gold and oil prices. The New Zealand dollar was the biggest loser, dropping another 0.8% against the greenback. We have been searching for reasons to explain the severe underperformance of the NZD and we finally have one. Last night, Reserve Bank of New Zealand Governor Wheeler expressed concerns about the strong level of the currency. While he admitted that their scope to intervene is limited and they would do so in only specific circumstances, their frustration with the 7% rise in the NZD/USD rate since the beginning of September suggests that they could delay their plans to raise rates. Wheeler indicated that lending limits may slow the pace of tightening but he still made it clear that rates will increase some time next year. We have a RBNZ meeting on the calendar next week and while we don't except the central bank to alter its hawkish bias, fresh concerns about the currency could make its way into the comments from the central bank which in turn could reduce rate hike expectations. No economic data was released from Australia or Canada but with a number of Chinese economic reports scheduled for release next week and the AUD struggling to hold onto its 0.96 breakout, the currency pair should come back into play.

Why USD/JPY Should Be Lower
The Japanese Yen traded higher against all of the major currencies except for the U.S. dollar and euro. The Nikkei dropped 2.75% overnight, which was the largest one-day decline since August. Reports that consumer prices rose to fiveyear highs contributed to the weakness in stocks and other yen crosses but the primary reason why equities performed so poorly is because of the persistent rise in Chinese rates. Higher interest rates in China has the same restrictive impact on the economy as higher interest rates in the U.S. and if yields on T-bills rose as quickly as short term instruments in China, the S&P 500 would probably be below 1700 and not above 1750. The one-week SHIBOR rate rose 21bp overnight to 4.89% while the one-month rate rose 102bp to 6.422%, taking the yield on both instruments to their highest level since July. Stock markets across Asia sold off sharply in response but there was little reaction from Europe and the U.S. Nonetheless, given the positive correlation between the Nikkei and USD/JPY, the currency pair should be trading lower. The same signal is coming from USD/JPY's relationship with U.S. yields. Ten year Treasury yields are at three-month lows, which suggests that USD/JPY should be weaker and if yields continue to fall due to disappointing U.S. data or more talk of tapering next year, USD/JPY could come under additional selling pressure. However, if for any reason the Nikkei or U.S. yields start to recover, this same correlation could fuel a stronger rally in USD/JPY.

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