The Dollar Remains Firm on Stronger US Outlook

BBH CurrencyView

The US dollar is broadly higher, continuing yesterday’s rally that intensified after the FOMC meeting. In the euro zone,there were no new developments but the euro made a marginal new low of 1.3031, while sterling is currently flat. The dollar climbed to an 11-month high of 83.51 against the yen, with resistance expected to come in near 84. The antipodeans are among the weakest performers in the G10. Global stocks pushed higher following the strong US close. The MSCI Asia Pacific Index is nearly 0.5% higher, while European shares are gaining the second day in a row. The EuroStoxx 600 is currently up 0.7% led by 2.1% gain in banking shares. Fed’s annual bank stress tests late Tuesday were well-received by the markets so far, with US stock futures pointing to an up open currently.

Euro zone remains quiet, for a change. However, negative dynamics remain in play. Greek press reports that the EU has asked Greece to detail fiscal measures worth EUR11.7 bln for 2013 and 2014 by June despite GDP that’s expected to contract in 2013 and stagnate in 2014. This comes after the EU asked Spain to cut an additional 0.5 percentage points of GDP from the 2012 budget, in response to Rajoy’s recent move. As recession deepens, this issue will remain a sore spot in both countries and in others.

US economic outlook continues to improve. February retail sales were stronger than expected. Equities rallied sharply as a result and, more importantly, the US Treasury market sold off. Near-term target for EUR/USD remains 1.2974 February low, but break of 1.2954 sets up a test of the January low around 1.2624. With Friday’s pattern still holding true, strong US data continues to translate into a stronger dollar. This change in dynamics can be seen in the breakdown in the correlation between the euro and the S&P 500. The 60-day rolling correlation on percentage changes has fallen to .4579, nearly half the peak of 0.8550 back in December. The 30-day correlation has fallen even more, to .4058 from .9092 in December. No major US data today, but markets will get the first glimpse of March with Empire and Philly Fed surveys on Thursday. Strong readings there could be the impetus for the next leg of the dollar rally.

The FOMC did tweak its outlook but maintained its pledge to keep rates low through 2014. We continue to believe that QE3 will be difficult to justify with US economic data continuing to firm. Yet with the Fed seemingly intent on anchoring the short end of the US curve, the 2-year UST yield continues to march higher, now at 35 bp and nearly double the year’s low around 20 bp. We note this because a big part of the story behind recent dollar strength is the noticeable shift in interest rate differentials. For instance, as dollar/yen rose today to the highest level since April 2011, the 2-year US-Japan spread is now around 24 bp, the highest since July 2011. We now target the April 2011 high of 85.53. The 2-year US-German spread is now around 15 bp, near the highest levels since June 2010.

The Norges Bank meets today and is expected to keep rates unchanged. Further easing measures are unlikely at this juncture given the better economic backdrop, but the Norges bank may lower the conditional rate path to a more neutral stance from the current one reflecting modest tightening expectations. The policy statement could also indicate concern about the impact the strong currency is having on the economy. The combination of a lower conditional rate path and a more cautious tone on the currency could be short-term negative for NOK. For EUR/NOK, resistance rests at recent highs near 7.52, with a break opening up a move to 7.678. Tomorrow the SNB meets and along with the rate decision, it will be publishing a monetary policy assessment containing the SNB’s inflation forecast path. The SNB is expected to keep policy rates unchanged and to maintain the EUR/CHF floor. However, it cannot be happy with deflationary pressures, with CPI down 0.9% y/y in February, worst since 2009.

Equity markets in China were down 2.5% bucking the global trend of positive risk appetite. The move was driven by comments by Premier Wen Jiabao suggesting that measures to support the property sector are off the table since prices were still far from reasonable levels. This is surprising to us. We view the risks associated with a sharp correction in housing prices as one of the key concerns in China and would expect the government to start moving to cushion these risks. We do not think NPLs from mortgage holders are the issue here as down payments tend to be very high. Like many observers, we are more concerned with the impact on real estate developers (which are highly leveraged) and local government financing vehicles (which depend on land sales). Large NPLs in these groups from a decline in housing prices could have a potentially devastating impact on the banking sector and could force the government to absorb that debt. Other headlines from Wen’s closing remarks for the NPC include further hints that the CNY appreciation trend is over for now and a widening of the trading band is indeed forthcoming. Note that 12-month CNY NDFs are pricing in depreciation for first time since mid-December.