USD Volatility Reflects Uncertainty

The volatility in the U.S. dollar Thursday reflects uncertainty about the outlook for the U.S economy. While tapering by the Federal Reserve is inevitable, the latest U.S. economic reports makes investors wonder if the central bank is acting prematurely. The Fed's primary concern is inflation but according to the consumer price report, inflationary pressures are muted. Growth on the other hand is uneven. Based on jobless claims, the labor market continues to recover but signs of weakness in other parts of the economy suggests that fewer layoffs may not translate into more hiring. Furthermore, the rise in yields will also make borrowing more expensive, a constraint that could slow the recovery. Ideally the central bank should reduce asset purchases when growth is on an uptrend not flat-lining but perhaps they fear that they may not have this luxury. Regardless, there is a lot of skepticism about how tapering could affect the economy and the concerns have led to big intraday swings in the dollar. Friday's University of Michigan Consumer Sentiment index will help to clarify the outlook but only if confidence improves. If it weakens, more doubts will surface.

The big news Thursday was the sharp rise in U.S. yields. Ten year Treasury yields hit an intraday high of 2.8% before settling down slightly lower. The last time yields reached this level was in July 2011 and in the past 3.5 months, yields have increased approximately 120 basis points. The rapid rise in yields could make the Federal Reserve nervous especially if it nears the 2.9% mark. In his speech this morning, FOMC Voter and Fed President Bullard admitted that higher "10 year Treasury note yield is a concern." The real question is whether this would affect the central bank's decision to taper and we believe that it could. If come September, 10-year Treasury yields are at 3% or higher, the amount of reduction in asset purchases could be smaller and the Fed will downplay expectations for additional tapering. December is still an option but its proximity to the holidays makes it a less desirable time to reduce stimulus than September.

The labor market continues to show signs of recovery with weekly jobless claims falling to 320K from 335K, the lowest level since October 2007. The four-week moving average is also closing in on its six-year low as the amount of layoffs continues to slow. The problem is hiring and while the unemployment rate has declined, the number of jobs created each month is barely enough to offset the number of new entrants. Nonetheless the fact that claims are moving in the right direction was enough to lift the dollar, although gains failed to last. Aside from jobless claims, the rest of Thursday's economic reports were tepid. Manufacturing activity, inflationary pressures and industrial production deteriorated in the month of July while foreigners were net sellers of U.S. dollars in June. Weak demand is keeping price pressures at bay with CPI and CPI ex food and energy rising only 0.2%. The Empire State Manufacturing survey slipped to 8.24 from 9.46, the Philadelphia Fed index fell to 9.30 from 19.80 while industrial production remained flat after growing 0.2% the previous month. Aside from the UMich survey, housing starts and building permits are also scheduled for release Friday.

EUR: More Range Trading Expected
Having traded down to a low of 1.3205, the EUR/USD staged a strong recovery to end the North American trading session higher against the U.S. dollar. With no economic reports released from the euro zone Thursday, the greenback dictated the direction for the pair although euro surged around the same time as the rally in gold. Since the beginning of the month, EUR/USD has been trapped between 1.32 and 1.34 and we believe that despite Thursday's rally this range will remain intact for the next 24 hours. Euro-zone current account, inflation and trade numbers are scheduled for release on Friday but none of these reports are significantly market moving for the euro because we already know that trade and current account balances improved significantly in Germany and France in the month of June. Inflationary pressures on the other hand have been more mixed. Germany reported an uptick in consumer prices last month while France reported a decline, which may be part of the reason why economists are looking for euro-zone CPI to fall. While the euro-zone recovery is still trailing behind the U.S. and the ECB is guiding monetary policy lower while the Fed is guiding it higher, the EUR/USD has not seen much volatility because investors are skeptical about how far the Fed will go. With such high expectations for the dollar and low expectations for the euro, next week's euro-zone PMI numbers will be key. Stronger manufacturing and service sector activity would confirm that the region stayed out of recession in Q3.

GBP: More Good News From The UK
The British pound extended its gains against the euro and U.S. dollar on the back of better than expected economic data. U.K. retail sales surged 1.1% in the month of July. While we have seen spending rise more this year, the three-month average reached its highest level since February 2008 and the year over year rate reached it's highest since January 2011. Core retail sales was just as strong, giving promise to Q3 GDP. The details of the report showed solid growth in supermarket sales along with strong online spending. While the recent string of good news will not affect the Bank of England's immediate plans for monetary policy (they just introduced the new unemployment rate threshold!), investors will start to consider if the central bank's unemployment and growth projections are overly pessimistic. The break of 1.56 in the GBP/USD is significant as this has been a key resistance level for the currency pair for the past month. The door is now open for a stronger rally to the June high of 1.5750.

NZD: Manufacturing PMI Hits 9-Year High
The volatility in the U.S. dollar also caused wild swings in the commodity currencies which recovered mid day losses to end the day higher against the U.S. dollar. Manufacturing activity in New Zealand improved significantly during the month of July with the PMI index rising from 55.2 to a nine-year high of 59.5. This marked the tenth consecutive month of expansion for the manufacturing sector which stands in sharp contrast to Australia, where manufacturing activity has been contracting for 17 straight months. This divergence explains why AUD/NZD has fallen more than 10% since the beginning of the year. Even though there have been more recent improvements in Australian data, the outperformance of New Zealand leads us to believe that AUD/NZD is poised to retest its four-year low of 1.12. The improvement in the manufacturing sector also contributed to the 3.5% increase in job advertisements and 2.7% increase in consumer confidence. While NZD/USD failed at 81 cents Thursday, it may be only a matter of time before this level is broken. Meanwhile the Australian dollar experienced steeper losses than the NZD due in part to consumer inflation expectations, which slowed to 2.3% from 2.6% in the month of August. Lower inflation expectations give the Reserve Bank stronger reason to keep monetary policy easy. Housing market activity in Canada continues to show signs of weakness with existing home sales growing a mere 0.2% last month compared to 3.3% in June. Manufacturing sales and international securities transactions from Canada are the only pieces of data expected from the three commodity producing countries on Friday.

JPY: Solid Japanese Demand For Foreign Bonds
Big moves in the U.S. dollar led to a widely divergent performance in Japanese Yen crosses. The Yen strengthened against the U.S. Australian and Canadian dollars but weakened against European currencies. The biggest story out of Japan last night was Cabinet Secretary Suga's denial that the Abe Administration is considering a lower corporate tax to offset the consumption tax. Japanese stocks responded negatively to the news, falling more than 2% as investors express their disappointment on the lack of relief provided to the economy. If Japan is really denied a corporate tax reduction, the consumption tax may have a more difficult time being passed especially on the heels of recent economic reports. The Cabinet kept its assessment of the economy unchanged this month. They still see the "economy picking up steadily and shows some movements on the way to recovery." Meanwhile Japanese investors were big buyers of foreign bonds according to the latest report from the Ministry of Finance. Purchases exceeded Y1.614 trillion last week, which was the largest amount since August 2010. Japanese investors have been net buyers of foreign bonds for the sixth week in a row and with U.S. yields continuing to press higher, we believe that this is officially a new trend.

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