Is Dollar Rally Done?
Kathy Lien | Dec 09, 2015 04:36PM ET
By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.
Crowded trades are getting killed this month with the U.S. dollar falling to 1-month lows versus the euro and Japanese yen. Considering that Treasury yields inched higher and there were no major U.S. economic reports on the calendar, the extent of Wednesday's unwind is surprising. However after being burned by selling euros pre-ECB, investors have become reluctant to hold long dollar positions into FOMC. But as each day passes, investors are also growing more confident that liftoff will begin this month. In fact, Fed futures contracts are now pricing in an 80% chance of a quarter point hike next week. So the key question to ask is whether the market has priced everything in and the dollar's rally is over. There's no doubt that this leg of the dollar's uptrend is nearing an end but there could still be another push higher before FOMC. The dollar may not be able to recapture its earlier highs, but there could still be some opportunity. Friday's retail sales report is the main U.S. event risk this week and given stronger job growth, higher wages, lower oil prices and the uptick in spending already reported by Redbook, the risk is to the upside for the report.
The following chart also shows a major divergence between USD/JPY and 2 year U.S.--Japanese yields. The yield spread is clearly signaling a higher USD/JPY but the currency pair continues to fall. This type of divergence rarely lasts for long and we believe that the earlier adjustment will be in the currency.
Aside from hitting a 1-month high, EUR/USD also broke 1.10. Unlike USD/JPY, there was a catalyst for the move in the euro. ECB member Nowotny called the market's expectations for more aggressive easing "absurd." These comments sparked another massive short squeeze in the currency. Although his views contrast with those made by ECB President Draghi last week -- in reaction to the sharp spike in the euro, the central bank head warned that they could deploy further tools if necessary -- investors didn't need more to drive EUR/USD higher. However 1.10 is going to be a difficult level for the ECB to swallow because it diminishes the effectiveness of its recent easing measures. The stronger currency will make reaching their inflation goals more challenging especially in an environment where oil prices have fallen 10% post ECB. Yet the magnitude of the EUR/USD short squeeze in undeniable and Draghi may be the only one that could stop the pair from rising higher.
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Sterling also traded strongly Wednesday ahead of the Bank of England's monetary policy announcement. The BoE is not expected to change the level stimulus Thursday but last month, sterling collapsed on the central bank's surprisingly dovish message. While the decline in oil prices this month gives policymakers more to worry about, sterling has also fallen in value versus the euro since the last meeting, which helps to offset some of the pressure on inflation. As shown in the table below, the economy has seen just as much improvement as deterioration since the last meeting but as we have learned in the latter part of this year, inflation is a far bigger concern for the BoE than growth.
The New Zealand dollar traded sharply higher after the Reserve Bank cut interest rates by 25bp to 2.50%. This counterintuitive price action was sparked by their forward guidance. Although the RBNZ expressed dissatisfaction with the high level of the currency and said they would reduce rates further if needed, they "expect to reach their inflation goal at current rate settings." This line suggests that they are not looking to lower rates again in the near term and this view is reinforced by their upgraded 2016 GDP forecasts. The RBNZ expects the economy to gain momentum next year as confidence improves and demand strengthens. Wheeler is weary of cutting rates more aggressively because it increases housing risks and he doesn't feel that it is necessary because inflation expectations are where they want them.
The Swiss National Bank also has a monetary policy meeting and after the ECB's easing, they will make it clear to the market that monetary policy remains very easy. After 2 strong days, USD/CAD ended the day virtually unchanged. Oil prices continued to slide even though oil inventories fell for the first time in 10 weeks. There are no major Canadian economic reports scheduled for release this week so oil remains the main focus for the currency. Canadian policymakers have already spoken and we know that the panic is growing. On Tuesday BoC Governor Poloz said negative rates would give them more room to maneuver. The central bank is open to lowering rates again but unconventional tools are not needed yet according to Poloz. We view 1.3525 to 1.3550 as attractive levels to buy USD/CAD for a move to 1.40.
AUD/USD also ended the day virtually unchanged ahead of Wednesday night's employment report as the decline in the commodity prices offset the drop in the U.S. dollar. Job losses are expected in November after a very strong October with analysts looking for Australia's unemployment rate to rise.
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