What's up with the dollar?

The buck is one of the worst performers in the G10 so far this month, and is down more than 4% vs. the GBP, and 3% vs. the NOK and AUD. Even the EUR, which has been weighed down by the ECB’s QE programme and the ongoing Greek sovereign debt crisis, has managed to eke out more than 2% in gains vs. the greenback so far in May.

What is driving the dollar lower, and can it last?

• US economic data continues to surprise on the downside, the Citibank economic surprise index for the US has slumped to a 3-year low, which could delay the timing of the first Fed rate hike.

• On that note, the market has also pushed back expectations for when the Fed will raise rates; the market now expects only 30 basis points of tightening before the end of the year, which is a little over 1 hike. If we continue to see weak economic data then a rate hike could be priced out for 2014 altogether.

• Momentum – the dollar has made a series of lower lows, and the downtrend continues to look entrenched. It has already fallen through key support including the 200-day sma and is below the daily Ichimoku cloud, suggesting that weakness in the buck could be here to stay.

The yield effect:

Interestingly, as you can see in figure 1, the dollar is selling off even though bond yields are rising. The 10-year Treasury yield is now at its highest level since November. Usually rising yields can lend support to a currency, but not so with the dollar. Why?

1. The dollar’s relationship with yields looks weak at best. It rose while Treasury yields were falling, and is falling as they rise.

2. If the rise in global DM bond yields is a sign that the global economy can avoid the scourge of deflation and is thus a collective sigh of relief, it would be natural for a safe haven like the dollar to weaken.

3. US yields may be rising, but they are rising faster elsewhere, for example in Germany, which is why the dollar cannot keep up. As you can see in figure 2.

Conclusions:

The dollar rally is on hold for now and has sold off some 7% since peaking in mid-March. This does not look like a mere pullback, if we continue to see weakness then it could be curtains for the dollar rally that the bulls were waiting so long for.

In the meantime, we would be cautious about looking for a reversal in the dollar at this stage, as the downtrend seems fairly entrenched. We think GBP could rally to 1.60 and beyond in the next week or so, and there may be further gains for EURUSD if we continue to see upward pressure on German bond yields. 1.1534, the high from end of Jan, is a critical level of resistance for EURUSD that opens the way for a return to 1.20.