Dollar Extends Gains As Central Bank Buys Gold

There is a new sense of energy in the FX markets today but the rally has been contained to only a few major currency pairs. The biggest gains are being enjoyed by USD/JPY and USD/CHF but AUD/USD and NZD/USD also recovered nicely. Euro and sterling on the other hand are struggling to gain any type of momentum -- upside or downside as the lack of market moving euro-zone data keep movements in these currencies limited.

Pleasant Surprises
At a time when the rest of the world economies are on shaky ground, U.S. economic data continues to surprise to the upside, making the dollar extremely attractive to global investors. Consumer confidence surged to its highest level in five years. Thanks to the improvement in the labor market and the persistent rise in stocks, the Conference Board's measure of consumer sentiment rose to 76.2 in May, up from 69. Greater consumer optimism should hopefully translate into stronger consumer spending in the second quarter. The Richmond Fed manufacturing index also rebounded to -2 from -6. While this was the second month in a row that manufacturing activity contracted, the improvements is a breath of fresh air for the sector. Finally, house prices increased 1.12% in March after rising 1.32% in February. This represents deterioration but for the first quarter, house prices are up 10.17% vs. 7.25% in Q4. As U.S. economic data continues to improve, expectations for tapering asset purchases by the Fed will continue to build and this sentiment should fuel further gains in the dollar.

Meanwhile, the IMF's report on central bank purchases of gold is getting some attention this morning and even though gold is lower, it is lending support to the beleaguered AUD and NZD. Investors have been eager to see whether the 18% decline in gold prices year to date attracted central bank buying and according to the International Monetary Fund, aside from Canada and Mexico, every major central bank has been hunting for bargains. Russia, Kazakhstan and Azerbajian collectively increased their gold holdings by 75%, cementing Russia's status as the world's number one buyer of gold. These three former Soviet Republics have been buying all the way down and while their demand has limited the slide in gold, it has not stopped it.

Gold
For most central banks, buying gold is part of their overall forex portfolio diversification strategy and the further gold declines, the more demand we expect because central banks are not as sensitive to short or medium term swings as traders or even investors. The outlook for gold hinges on the outlook for the U.S. dollar and for the time being, expectations for a reduction in asset purchases by the Fed should keep the dollar bid. According to the CFTC's latest positioning data, fund managers and speculators are grossly short gold and we believe that the prices could head lower.

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