Dollar: No Surprises, Taper To Continue

Dollar: No Surprises from Fed, Still Plans to Taper

There was very little consistency in the performance of the U.S. dollar Wednesday and quite a bit of volatility in U.S. equities. The Dow Jones Industrial Average started the day strong, gave up all its gains by noon, bounced before 2pm only settle down over 85 points. The performance particularly against the Japanese Yen mirrored the movements in equities albeit on a far more micro basis. The greenback traded higher versus the euro, Canadian dollar and Swiss Franc Wednesday but moved lower versus the Japanese Yen, Australian and New Zealand dollars. This morning's U.S. economic reports left a lot to desired. Housing starts dropped 16%, the largest amount in 3 years while building permits fell 5.4%. Producer prices rose slightly by 0.2% but the rise in inflationary pressure is too small to raise the central bank's concerns.

The Federal Reserve released the minutes from their last monetary policy meeting and it contained very little surprises. FOMC Voters Fisher and Plosser's opposition to the extension of the repo tool is mildly positive for the dollar because it suggests that they are not as dovish as some of their peers. The Fed also plans to change its rate guidance as the unemployment rate falls but they did not provide any details on how it would be altered. We know that some members favor a qualitative guidance that doesn't handcuff the central bank to a specific economic indicator. There's a very good chance the Fed will follow in the Bank of England's footsteps and drop their unemployment rate threshold next month.

Fed Presidents Lockhart, Williams and Bullard provided more insight into the central bank's thinking but as non-voting members of the FOMC, their views do not have a direct impact on monetary policy. Nonetheless, Lockhart sees QE ending by Q4 followed by the first rate hike in the second half of 2015. He is optimistic about the outlook for the economy. Williams also agrees that while recent data has been disappointing, the economy is looking really solid for this year. Bullard shares their optimism and along with Williams believes that the Fed should move away from explicit thresholds. For the most part, they all feel that the hurdle is pretty high for changing the pace of tapering. Given Janet Yellen's recent testimony on Capitol Hill, we believe she shares these views. Consumer prices, jobless claims, the Philly Fed index, Conference Board consumer confidence index and leading indicators are scheduled for release Thursday. Most of these reports will still be impacted by inclement weather.

EUR: All Eyes on Flash PMIs

The euro traded lower against the U.S. dollar Wednesday and while the strength of the greenback can be blamed for part of the move, the turmoil in Ukraine also weighed on risk appetite. Thanks to yesterday's breakout, EUR/USD is trading firmly above 1.37, a level that we have been watching closely for the past few weeks. Whether the currency pair will be able to extend higher will depend largely on Thursday's Eurozone flash PMI reports. The surprise decline in the ZEW survey along with recent pullback in factory orders and industrial production puts the odds in favor of a weaker release. While the Eurozone economy has been recovering slowly, growth has been uneven. This makes us weary of the recent rally in euro. If the Flash PMIs surprise to the downside, indicating a slowdown in Eurozone economic activity, we could easily see EUR/USD drop back below 1.37. If the data is good, the currency pair should climb to fresh year to date highs.

Behind the Rally in USD/CAD

It is extremely rare to see USD/CAD as the day's biggest mover and Wednesday's move is particularly interesting because there was no clear fundamental catalyst. If the Bank of Canada suddenly dropped interest rates, we would not be surprised by a 1.2% rally in USD/CAD but wholesale sales which is an often ignored piece of data was the only Canadian economic report on the calendar. Granted wholesale sales dropped a whopping 1.4% in December, the third decline in 4 months, it has fallen more in the past year and yet elicited a smaller reaction. Nonetheless, there is a decent correlation between Canadian wholesale sales and retail sales, which are scheduled for release on Friday. Wednesday's steep decline raises the risk of a similarly large drop in retail sales. The abundance of weak Canadian data and the Bank of Canada's dovishness is finally catching up to the currency. Aside from economic data, the intraday rally in the dollar also contributed to the rise in USD/CAD. Earlier Wednesday, Canadian Natural Resources announced plans to buy part of U.S. based Devon Energy's Western Canadian assets in a cash deal that creates a positive M&A flow for USD/CAD. The Australian and New Zealand dollars also weakened against the greenback. Producer prices in New Zealand declined in the fourth quarter due to lower electricity and dairy prices. This decline caught the market by surprise and sent NZD lower. Wednesday night's HSBC flash PMI report for China was expected to influence how AUD and NZD trade over the next 24 hours. If manufacturing activity in China continues to slow, we could see a steeper sell-off in the commodity currencies.

GBP: Higher Unemployment Rate is Not Always Bad

The British pound recovered its earlier losses to end the day unchanged against the U.S. dollar. The initial weakness in sterling during the European session was driven by a surprise increase in the unemployment rate. Given the Bank of England's decision to drop its 7% unemployment rate threshold, many economists expected the jobless rate to remain unchanged OR fall from 7.1% to 7% but instead it increased by 0.1%. Based on the price action in GBP/USD, the number obviously caught the market by surprise but the details of the report are not nearly as weak as the headline number. First and foremost, jobless claims dropped more than expected in January, which is a sign of improving labor market conditions. Average weekly earnings also rose slightly more than expected. The rise in the unemployment rate is discouraging but not when you consider that it was caused by an increase in labor supply. There is enough optimism in the U.K. for people out of work to begin actively looking once again and when that happens a higher unemployment rate is not always negative for an economy. However this does not diminish the fact that some investors are weary of the recent disappointments in U.K. data. Between the larger decline in consumer prices and higher jobless rate, there are some skeptics who believe that the recovery is losing momentum. With the latest CFTC IMM report showing significant amount of speculative long positions, unambiguously positive data will be needed to drive fresh longs in the pound. The Bank of England also released the minutes from its last meeting and according to our colleague Boris Schlossberg, " The minutes essentially reaffirmed the policy as the members voted unanimously to keep rates and QE measures the same, but takeaway line from the meeting was that there was room to absorb spare capacity before rate increases. The MPC is clearly trying to temper market expectations regarding any tightening as policymakers continue to believe that UK economy has plenty of slack still left in it."

USD/JPY: Vulnerable to Weaker Trade Data

The Japanese Yen ended the day unchanged against most of the major currencies. An intraday rally in USD/JPY helped to erase earlier losses in many of the Yen pairs except for CAD/JPY, which came under heavy selling pressure during the North American trading session. The mild sell-off in the Nikkei overnight did not help but the rise in U.S. Treasuries prevented steeper losses. Last night's Japanese economic reports were mixed. The leading index for the month of December was revised lower but Nationwide and Tokyo department store sales increased strongly in the month of January. An increase in consumer spending is a positive sign that we expect to continue ahead of the April consumption tax. Both the Bank of Japan and Cabinet Office left their assessment of the economy completely unchanged for the month of February. The BoJ says the economy "has continued to recover moderately and front loaded increase in demand prior to the consumption tax hike has recently been observed." The Cabinet was more concise, describing the economy as "recovering at a moderate pace." The country's trade balance was scheduled for release Wednesday evening and unfortunately rising energy costs and weakening regional demand was expected to increase the trade gap. If export growth slows even more than expected, the Nikkei could extend its losses, dragging USD/JPY down with it.

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