Sympathy for the Dollar
- The dollar rally continued as US economic data continues to outperform, leading US bond yields higher. US 2- and 10-year yields have increased by 17bp and 67bp over the past month and the rise in the 10-year to 3.51% is nearly a full retracement of the highs in March. This can be viewed as a normalization process for the curve due to the higher US growth expectations, arising from better data and the new stimulus package, which is likely to be passed this week. The stimulus package is expected by some economists to add 0.5 – 1.0% to growth in 2011, which would increase the y/y consensus growth outlook to 3.1% – 3.6%. As such, passage of the stimulus package may also help support the dollar in 2011 since fiscal support is likely to lift some of the burden off the Fed. Indeed, passage of the new package may shift market expectations towards the Fed ending its large scale asset purchases program by June, and away from the likelihood of having to expand it. In the next two weeks, the US will report revised Q3 GDP, new and existing home sales, durable goods, University of Michigan consumer confidence, Chicago PMI, the regional Fed indices and others. We expect US data to remain robust, as we note that with the exception of the last month’s jobs report, most US data prints have come in on the strong side.
- The European debt crisis is likely to remain a major driver in the weeks ahead, and medium-term investors are best positioned to be short euros heading into 2011. Despite better-than-expected data from Germany, German bonds have started to come under pressure as investors become more concerned about the likely outcome of the euro-zone debt crisis. Indeed, the rise in German yields suggests that investors are nervous about the possibility of German liabilities increasing on the back of EMU funding issues. Although we feel that the probability of a euro-zone breakup is low, markets are viewing it as possible rather than unthinkable. European policy makers continue to be reactive to problems and have yet to get ahead of the curve to quell market fears. Meanwhile, with a host of elections in 2011 (Germany and Ireland in March) and the bond resumption schedule front-loaded in the first quarter of next year, it is likely that European policy makers remain on their back foot and as a result the euro remains soft. Over the next few weeks the European economic calendar is light but important events will take place. The EU summit ends tomorrow, Greece will vote on the 2011 budget on 12/22 and the last three big peripheral auctions take place. There will be one in Spain on 12/21 and two in Italy on 12/29 and 12/30.
Short-term trading recommendations:
Stay short AUD/CAD with a stop of 1.009
This trade was close to getting stopped out when it reached 1.008 but we still feel the fundamentals supporting this trade are strong. US economy is showing signs of improvement, while China grapples with inflation and further PBOC interest rate hikes loom bringing with it concerns about a China hard landing. With Canada’s strong ties to the US economy and Australia’s strong ties to the Chinese economy this trade attempts to exploit the difference between the immediate growth outlooks between the US and Chinese economy.
Stay short EUR/NOK with a stop of 8.15
The issues in peripheral Europe are far from resolved. Combined, Portugal and Spain have heavy bond redemption schedules in January, February and March totaling nearly €42bln. In addition, any weakness in the Spanish housing or labor market could weigh on the private sector banking system. Meanwhile, the economic outlook for the Scandis remains relatively good. The Norges Bank, as expected, did not hike this week but acknowledged higher-than-expected growth prospects for its trading partners and OIS swaps imply a additional 36bp increase in the overnight rate over the next year. We have a medium-term target of 7.88.
Buy USD/JPY at current levels with a stop of ¥83.10
We expect the US dollar uptrend to continue with the strength of US economic data leading to increased US yields. The higher yields, in turn, have helped the dollar to rally against the yen, with dollar/yen continuing to test the late November high of ¥84.41. If the dollar can convincingly break that level the next target is the full retracement of the recent move back to the September high, around ¥85.93. After that, we have target of ¥86.30 over the next month, options pricing suggesting there is a 50% probability of meeting this target.