Its Risky Buying Dollars After China Rate Cut and ECB

It has been a great week to be long U.S. dollars and the source of the greenback's strength is monetary policy divergence - one of the most meaningful drivers of currency flows. First it was the ECB who set expectations for December easing and today China slashed interest rates, lowered their reserve requirement ratio and warned that they could ease further. The latest moves by the ECB and China are a double-edged sword for the Fed. One of the Federal Reserve's greatest concerns last month was the strong dollar and easier monetary policy abroad will drive the buck higher. This is a problem for Janet Yellen because a strong currency hampers inflation and trade activity. Also, China and the ECB are taking steps to stimulate their economy to counter slowdown and global uncertainty was also one of the Fed's main concerns. So while it can be argued that stimulus abroad is good for U.S. markets and makes it easier for the Fed to raise interest rates in December, the reasons why these central banks are easing and the consequence it has for the dollar could also deter them from tightening.

We are long-term dollar bulls but the "trader in us" see the risk being long dollars ahead of next week's FOMC meeting. In other words we will either be looking to sell dollars into FOMC or buy it at lower levels after the Fed meeting. Expectations for Fed tightening shifted significantly since September. Last month, Janet Yellen suggested that rates could be increased in October and accompanied by an unscheduled press conference. These hawkish words drove the dollar higher but after weak non-farm payrolls growth, stagnant wages and disappointing consumer spending numbers there's zero chance of a move this month. In fact, they could even stand down in December. The Federal Reserve is in a very difficult to position - many policymakers are ready to raise interest rates but recent economic reports discourage a move. Don't expect the FOMC statement is not likely to provide much clarity on monetary policy. Many U.S. policymakers still believe that rates could rise this year but nearly all want to see back to back strength in U.S. data from here on forward before tightening.

For this reason, third quarter U.S. GDP numbers could trigger a larger reaction in the greenback than the FOMC meeting because no one expects the Fed to move. GDP is expected to have slowed significantly between July and September. Trade activity was hit hard by the strong dollar and there was only 1 month of good retail sales - the rest was ugly. Aside from FOMC and GDP, more housing reports, durable goods, consumer confidence, jobless claims, personal income / spending and the Chicago PMI reports are scheduled for release. Keep an eye on the consistency of these reports because they contribute to the volatility in the dollar.

Besides the Fed, the Bank of Japan and the Reserve Bank of New Zealand also have monetary policy announcements. Like the U.S., Japanese economic reports have taken a turn for the worse since the last central bank meeting. Normally BoJ meetings are not very exciting but many economists believe that the central bank could increase stimulus. However at the beginning of the month, there was very little urgency to move and not much has changed for Japan since then. Yet in October of last year, the BoJ sent USD/JPY soaring after they shocked the market with more easing. Considering that this is a valid risk next week, traders should be cautious about trading the Yen Thursday/Friday.

The RBNZ won't be happy that one of the best performing currencies this month is New Zealand dollar. No changes in monetary policy is expected from the Reserve Bank but given recent data and increase in dairy prices, investors are hoping for less dovish comments. We may hear some optimism about the economy but the central bank could also express renewed concerns about the currency. In the past month, NZD/USD has risen from a low of 0.6250 to 69 cents while AUD/NZD has fallen from a high of 1.1350 to a low of 1.0575. The stimulus from China helps ease some of the RBNZ's concerns but we would be surprised if they did not mention the recent appreciation of the currency.

The euro will remain under pressure in the coming week. Investors eyed today's stronger PMI reports will skepticism after the ECB prepared the market for December easing. If given the opportunity we will be looking to reload our EUR/USD short positions looking for a move below 1.10 and possibly even 1.09. A handful of Eurozone economic reports are scheduled for release next week including the German IFO report, unemployment, Eurozone confidence and inflation data. A number of EZ policymakers are also scheduled to speak and any dovishness could extend the losses in euro.

GBP will take a back to seat to the other major currencies but only after Tuesday's Q3 GDP report. Monetary policy divergence is driving currency flows and if growth surprises to the upside (and we think it could after the strong retail sales reports), sterling could see strong gains against many major currencies.

Australia has Q3 CPI numbers and Canada has its August GDP report scheduled for release but AUD and CAD will most likely to take their cue from commodity prices, risk tolerance and the market's appetite for U.S. dollars.