The Narrative Speaks

For two weeks the dollar’s been hammered
As traders, for Krona have clamored
The narrative speaks
Of a dollar quite weak
A view with which I’m not enamored

But now that the New Year has started
With tax laws for earnings recharted
A new attitude
Ought soon be pursued
But this won’t be for the fainthearted

In the two plus weeks since I last wrote, the dollar has been sold off consistently, with the Swedish and Norwegian Krona(e) the biggest gainers in the G10 space, rallying between 3.5% and 4.0%. Pretty impressive movement in a short period of time! But across the entire G10, the dollar was the weakest currency as the narrative continues to focus on the idea that the Fed will be forced to slow down their current trajectory of interest rate increases while we will see a much quicker pace of tightening elsewhere in the world. For those of you who looked through my forecasts yesterday, it is clear I disagree with that story. However, as long as enough players in the market continue to believe the story, the dollar will remain under pressure.

So what can change that view? We will need to see the inflation story become much clearer for the US, meaning rising wages and prices, as well as ongoing dovishness from certain central bankers, notably Mario Draghi, in the face of an improving economic situation in Europe. And the improving economic situation in Europe continues apace. Yesterday saw the PMI data in Europe confirmed at its highest level since well before the financial crisis and this morning added record low German Unemployment to the mix. Certainly the story in Europe’s largest economy has been a success, but as yet, like elsewhere in the developed world, faster growth has not led to higher prices. And all of the commentary we have heard from Mario Draghi and his ECB brethren continues to focus on the lack of inflationary pressures as the root cause for the ECB’s need to continue to support the economy. In other words, while QE in Europe will be cut in half from last year’s levels starting this month, they are still adding assets to their balance sheet and continuing to cap Eurozone interest rates.

On the other side of that trade is the US, where the Fed has already embarked on its tightening campaign, both raising rates and allowing the balance sheet to start to shrink. In many ways I think the latter issue will be much greater, especially with the government’s growing need to issue significantly more debt to cover a growing budget deficit. The upshot is just as we are slated to get a big increase in supply this year, the biggest bid for Treasuries is going to shrink. To my knowledge, the laws of supply and demand have yet to be repealed, and that situation means that Treasury prices seem certain to decline as the year progresses. In my view, higher Treasury yields will be the key to underpinning the dollar’s surprising (to the market) strength this year.

It is important to remember that it was not just the G10 currencies that benefitted during the second half of December, but almost all emerging market currencies rallied as well. In fact the only two laggards there were the Argentine and Mexican pesos. As to the former, the story revolved around a relaxation in inflation targets for the next two years allowing easier monetary policy there to support growth. Of course, easier monetary policy (read lower interest rates) is anathema for an emerging market currency, hence the decline. Meanwhile, just south of our border it seems that the basic story driving the Mexican peso’s decline was concern over a growing campaign-finance corruption scandal, which was seen as a boost to AMLO and a more radical presidential outcome this summer. While both these currencies have rebounded somewhat from their worst levels of the period, it is important to remember that both have issues that can lead to further weakness. But elsewhere in EMG, it has been dollar bashing as well.

With the first week of the month upon us, we are due to be saturated with data as follows:


Today Construction Spending 0.5%
  ISM Manufacturing 58.2
  ISM Prices Paid 64.5
  FOMC Minutes  
Thursday ADP Employment 190K
  Initial Claims 242K
Friday Nonfarm Payrolls 190K
  Private Payrolls 185K
  Manufacturing Payrolls 20K
  Unemployment Rate 4.1%
  Avg Hourly Earnings 0.3% (2.5% Y/Y)
  Avg Weekly Hours 34.5
  Trade Balance -$50.0B
  ISM Non-Manufacturing 57.5
  Factory Orders 1.1%

All eyes will be on today’s FOMC Minutes as traders and investors want to see more about the inflation discussion at the Fed. And then, of course, Friday’s payroll data will be key. Any hint that wages are rising more rapidly than forecast should be seen as an immediate dollar positive. Also, watch the Unemployment rate as if it were to decline further, it would also ratchet up pressure on the Fed.

As to today’s trading, the dollar seems to have stabilized after its recent declines. My sense is it will be responsive to the impressions from the Minutes, but that traders are really looking ahead to Friday.

Good luck