What Does Return To Normalcy Mean For The Dollar?

It is back to the basics for the foreign exchange market this week with the U.S. government open for business and slowly returning to normal conditions. In the short term this means delayed economic reports will start to trickle in but in the medium term, the bigger implication is a return to value for currencies. Over the past few months, two biggest risks for the FX market were the U.S. fiscal crisis and Fed tapering. Now that both of these risks have been pushed out to 2014, currency flows over the next 11 weeks will be driven by the individual performance of major economies and the direction of monetary policies. In the U.S. specifically, the focus will be on a number of delayed reports including tomorrow's non-farm payrolls release. While economists are looking for stronger job growth, the steep slowdown in labor market conditions in the service sector suggests there's scope for a downside surprise. Even if the data beats expectations, policymakers will most likely take the reports with a grain of salt. Instead the Federal Reserve has its eye on next month's releases, which will show how much the U.S. government shutdown cost the economy in the month of October. We believe that a large part of these reports will be weak, keeping the dollar under pressure throughout the fourth quarter.

Potential Distortion
Federal Reserve President Evans, who is a voting member of the FOMC this year, made it clear in his comments this morning that the central bank is watching incoming data and not surprisingly, he believes that it will take a few months to sort out the U.S. labor market picture. It will be difficult for the central bank to pull the trigger on tapering asset purchases over the next few months because of the potential distortion in many upcoming economic releases. We won't get a true indication of how well the U.S. economy is holding up until December, when the November reports are released and that timing is too tight in our opinion for the Fed to legitimately pull the trigger on tapering. As this leaves the first move for the Fed in 2014, rates will remain suppressed for the rest of the year, making it difficult for the dollar to rally.

So while the greenback is trading higher against all of the major currencies this morning, the move is most likely nothing more than a quiet relief rally. The greenback was hit hard last week against high beta currencies and on a percentage basis today's rally is nominal in comparison. The move was supported by U.S. existing home sales, which dropped only 1.9% in the month of September compared to a -3.3% forecast. However there is more than meets the eye because sales in August was revised down to flat from up 1.7%. Taken together, the housing market could be a growing area of concern for the central bank.

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